Advisors have long wrestled with the question: Should I use active or passive strategies to build my clients’ portfolios?
At face value, it seems simple. Index funds offer low costs and broad diversification. Active managers charge more and don’t always deliver. But when market dynamics shift and new risks emerge, more nuanced questions surface: What unintended risks might be embedded in an index fund? And when can active managers deliver more than just market returns?
The active-versus-passive conversation is often framed as binary. It shouldn’t be. When done well, active management offers distinct benefits that passive simply can’t replicate, especially in today’s environment of concentrated market returns, rich valuations, and increased volatility. There is a real opportunity for advisors to identify active managers who consistently add value and use them as the foundation of a resilient investment strategy.
Active Management: More Than Trying to Beat the Market
At its core, active management is about being selective in the pursuit of returns that exceed a benchmark. For the investment teams at Madison Investments, this pursuit starts with risk awareness, valuation discipline, and a willingness to break from the herd.
We believe active investing means thoughtfully positioning portfolios to participate in up markets while protecting capital in down markets. At Madison, we do this by focusing on quality, all-weather companies with durable earnings growth. It’s an approach that features high active share to pursue low downside capture and consistency. No guesses, no unnecessary risks, no big gambles. Just rigorous analysis and a time-tested process.
That kind of approach is becoming increasingly relevant. Recent market returns have been driven by a handful of mega-cap names and sectors, presenting an opportunity for active managers to avoid overconcentration and reallocate toward undervalued areas, something passive, market-cap-weighted funds can’t do.
Passive Investing Isn’t Risk-Neutral
Passive investing is often viewed as the “safe” or “neutral” choice. A way to participate in the market without placing any big bets. But that perception can be misleading.
Today’s major indexes, especially the S&P 500, are heavily concentrated. It’s been well-documented that just a handful of mega-cap stocks now make up an outsized portion of the index, meaning investors in passive strategies are increasingly exposed to a narrow group of companies, regardless of their valuation. As those stocks rise, index funds automatically allocate more to them. There’s no price sensitivity, no valuation discipline, just momentum.
Weight of the Top 10 Holdings in S&P 500 Index
This lack of selectivity creates risk. If the most heavily weighted companies in the index stumble, there’s no offsetting mechanism. Passive funds are fully exposed to that downside. There’s no built-in buffer or margin of safety, no reallocation to more defensive sectors or more attractively valued stocks, and no risk management. Just full participation, up or down.
Why might this matter now? Taken in aggregate, stocks in 9 of 11 sectors are priced at a premium to their historical averages, giving little margin for bad news. An active manager will work to understand the drivers of a stock’s valuation and future earnings potential, allocating to the companies that they believe offer the best value, margin of safety, and return potential going forward.
For advisors building long-term portfolios, it’s important to recognize that passive investing is a very active choice.
Seeking Differentiation Among Active Managers
Passive equity investors expect their returns to generally track closely with the index that their fund or manager mirrors, often at a low fee. In contrast, active management is seen as inconsistent, and finding a manager who reliably outperforms after fees can be challenging. But what if there was a way to “separate the wheat from the chaff” and identify those active managers whose approach consistently provides the opportunity for outperformance?
We believe that advisors and investors are best positioned to achieve market-beating performance by using the following tools in selecting active managers:
1. Active Share
Active share measures how much a portfolio’s holdings differ from its benchmark. The higher the active share, the more a manager is expressing independent conviction rather than conforming to an index, increasing the opportunity to outperform the market.
A high active share (above 80%) can be beneficial in managing downside risk during volatile markets.
High active share alone doesn’t guarantee outperformance, but it does tell you the manager isn’t simply replicating the index. It should be analyzed in concert with the next criteria: downside protection and consistency.
2. Downside Protection
Avoiding losses is more powerful than capturing every last basis point of upside. A manager who sidesteps major drawdowns helps preserve capital, making it easier for a portfolio to recover and compound over time. We measure this with the downside capture ratio.
Mathematically, it takes a 43% gain to recover from a 30% loss. In the past 25 years, the S&P 500 has fallen 30% or more 3 times. Limiting drawdowns through risk-aware positioning is one of the most effective ways an active manager can add value, especially during market corrections, sell-offs, and bear markets.
3. Consistency
Assessing a manager’s performance across a full market cycle is crucial for understanding the advantages of their active approach and their ability to navigate challenging markets.
Rather than chasing hot hands or top-quartile rankings, look for repeatability. A manager who consistently lands in the top half of their peer group year after year may offer better long-term results than one who shoots to the top one year and falls to the bottom the next. Managers who consistently protect on the downside are better positioned to deliver outperformance over a full market cycle.
Consistency signals process. It tells you the manager has a philosophy they stick to and that they’re not relying on luck or market timing.
Meeting the New Bar in Active Management
In recent years, the growing concentration of indexes and exuberance over the top names have made it challenging for active managers to compete with the index. But that doesn’t mean active management has failed; it just means the bar has been raised. Advisors today don’t need to choose between active and passive. They need to choose between high-conviction, consistent active managers and everything else.
By focusing on active share, downside protection, and consistency, you can identify managers who truly differentiate themselves and help your clients build portfolios designed not just to match the market, but to navigate it with confidence.