The Better-of-Two Strategy for Active versus Passive Management: The Option Value of Active through Time

Abstract

Instead of forcing a choice between active and passive portfolios, we create a better-of-two option to (1) calculate active management’s value and (2) find the optimal weights for an active-plus-passive portfolio that dynamically replicates this option through time. To replicate the option at a 10-year horizon, the strategy initially allocates roughly 60% to the active asset. Using historical returns and 60/40 portfolios, ending wealth distributions in excess of the all-passive portfolio using the better-of-two strategy significantly exceeded those of an all-active strategy with superior downside protection. Investors could implement this strategy with institutional or individual separate accounts, institutional funds, or a single fund with passive and active subportfolios.