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For retirees with defined contribution retirement plans or active workers who are accumulating funds toward retirement in a defined contribution plan (which covers most of us these days), one key issue in selecting investments for a plan is the decision of whether to use actively managed funds or passive index funds to fund your plan.

This issue really is a never ending debate that most likely never will be settled definitively. However, it is possible for active and passive approaches to logically coexist in the context of what might be called investment management in a nearly efficient market.

Active vs. passive management

Passive management generally refers to the use of index funds, which simply are mutual funds constructed to track the performance of some stock index. An S&P 500 index fund, for example, simply buys all 500 stocks in the Standard & Poor’s 500 Index SPX, -0.61%  in exact proportion to each fund’s weight in the index based on its outstanding market capitalization (price per share times the number of shares outstanding).

Thus, Apple, the largest market cap stock in the index, would be assigned a weight of 2.8% of the total fund, and Exxon Mobil, the second largest cap stock would be weighted as 2.5% of the total fund (market caps as of Jan. 31).

The argument in favor of investing in index funds rests on the economic concept of market efficiency, which essentially states that stocks in aggregate are priced efficiently such that their market prices fairly reflect the intrinsic value of the stock. If stock prices were perfectly efficient, there would be no sense in doing any kind of analysis to try to outperform the efficient market.

This has been a hotly debated point in finance for nearly 50 years now and Warren Buffett, for one, has been famously quoted as saying that telling investors that markets are efficient is akin to telling bridge players that it doesn’t do any good to look at the cards.

Active management generally refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index in an attempt to produce above-average returns on a risk-adjusted basis.

Active managers exploit market inefficiencies by purchasing securities that are undervalued or by selling securities that the manager believes are overvalued. Active managers may use a variety of factors and strategies to construct a portfolio including quantitative measures such as price-to-earnings ratios, attempting to anticipate long-term macroeconomic trends and/or purchasing stocks of companies that are temporarily out-of-favor or selling at a discount to the company’s intrinsic value.

A core/non-core compromise

There is a deep well of academic studies to support the position that the market for large-cap U.S. stocks is highly efficient, even if not perfectly efficient. However this market is close enough to efficiency that for most investors, the best returns will come from investing solely in index funds in the large-cap sector.

As one moves out of the large-cap space into midcaps (generally $2 billion to $12 billion average market cap) and small caps (generally less than $2 billion average market cap), markets become less efficient and the probability of outperforming an index fund with actively managed funds increases. This is a market segment where a core/noncore approach makes sense: Index the core (say 40% to 50%) of your mid and small-cap investments in index funds and invest the rest in actively managed funds.

This approach also works well in selecting international funds: Diversify across cap sizes and use a mix of indexed and actively managed international or global funds.

Finally, in the alternative investments sphere (which would include funds that invest in assets such as real-estate investment trusts, commodities, energy limited partnerships, emerging market stocks and bonds, long/short strategies, and other assets), where the market becomes less efficient, you may be served best by investing only in active funds.

The particular mix of passive and active funds that you deploy in your investment strategy will largely depend on your comfort level with active funds in each market segment.