As every stock picker knows, it’s hard to beat an index. This truth is demonstrated by a recent study from The Vanguard Group. See charts below.

But here’s the catch. With passive indexing so popular, an active overlay is increasingly important. Perhaps even mandatory for investment survival in today’s richly valued world.

What’s an active overlay? We used to call it “market timing,” but that phrase is out of fashion. The modern terminology is “asset allocation” – or “tilting,” if you prefer. Choose your label. The meaning is the same. Percentage allocation toward stocks, bonds, cash, gold, etc. is the most important driver of total return.

There is increasing evidence that the success of passive-versus-active styles is dependent on market regime. Scott Opsal, Director of Research at Leuthold Group, has done some solid work in this area. His studies suggest that active style outperforms in bear-market environments:

Relative performance of active and passive mutual funds is one of the leading story lines in our industry, with passive’s recent advantage leading some to argue that it will be the dominant style forevermore. We disagree, and believe that the active/passive relationship has been, and always will be, cyclical.

Bull and bear markets will always exist. The issue of market timing is unavoidable. The more passive the investment world becomes, the more active we may need to be. Hyper activity is a losing strategy for most. Gradual adjustments based on valuation and behavioral considerations, however, are likely to add value over a long investment horizon.

According to a recent study from Matt Kandar and James Montier of Grantham, Mayo, Van Otterloo & Co., passive style may even rise to speculation:

The decision to be passive is still an active decision – and we would suggest one with important risks that investors are not paying adequate attention to today. As more and more investors turn to passively-managed mandates, the opportunity set for active management increases. A decision to allocate to a passive S&P 500 index is to say that you are ignoring what we believe is the most important determinant of long-term returns: valuation. At this point, you are no longer entitled to refer to yourself as an investor. You may call yourself a speculator, but not an investor.

Our perspective?

There are obvious advantages to passive style. Excessive passivity, however, may be hazardous to your investment health. It’s okay to embrace indexing but consider an active overlay. Especially for defensive work.