The turmoil in the high-yield market will — and should — add fuel to the debate about the merits of active versus passive investment. Both sides of this increasingly heated discussion will find reason to harden their convictions.

Yet the recent developments should add nuance to a discussion that has been dominated by the two most extreme positions: The  advocates of passive investment in every case, and those who swear only by the active approach for almost every asset class.

The recent selloff in junk bonds reflects a combination of rich initial valuations, credit deterioration and a worsening in market liquidity. This has been exacerbated by imbalanced indexes — in which energy and energy-related stocks are given a relatively heavy weight. It also is driven by the proliferation of investment vehicles that offer investors the illusion of delivering both high returns and daily liquidity in a cost-effective manner, regardless of inevitable market dislocations. Adding to the volatility, at least two funds have limited the ability of  investors to withdraw capital.

Advocates of the active strategy will note that investors who relied on indexing ended up overexposed to energy and energy-related risk. As a result, they were particularly hard hit by the collapse in oil prices. As liquidity-induced contagion spread to securities in others sectors with more solid fundamentals, the remaining diversification potential of the high-yield index brought them little relief. And those seeking to pull out their money faced additional losses thanks to widening bid-offer spreads.

Advocates of passive investments will note that the biggest losses in the asset class so far largely have been  incurred by active funds. This is especially true of managers who ventured away from the index and into more exotic, even-more-illiquid names. Inadequately constructed portfolios are adding to their woes, and some of these funds are having trouble raising cash, further undermining their investment strategies.

None of this is new: Emerging-market investors have repeatedly found themselves in similar situations. For example, on the eve of its default in 2001, Argentina accounted for more than 20 percent of some emerging-market indexes. A passive approach exposed investors to enormous default risk, and some active investors had doubled up on Argentina risk in their quest for the highest-yielding paper.

There are two immediate takeaways:

• Investors should be wary of adopting a passive approach in asset classes subject to high credit/default risk and in which weights are calculated on the basis of the debt outstanding for each issuer (which, unfortunately, is the traditional approach to the design of too many indexes).
• Those following an active approach should be cautious about asset managers who combine an open-ended vehicle offering daily liquidity with a repeated strong inclination to venture deep into exotic and illiquid names in search of returns.

A wider application of these two simple principles leads to a broader conclusion:

Rather than focus on extremes, a responsive mix of passive and active investments is the best approach for many investors. They should be inclined to use passive approaches for asset classes that are heavily favored by the investment community as a whole, and where the addition of alpha is inherently difficult. They also should be more attracted to active approaches for the less popular market segments, such as exotic asset classes, for which they can use liquidity-conscious managers with well-tested investment processes, rather than relying on vulnerable indexes.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story: Mohamed A. El-Erian at [email protected]