I've never met a fund manager who told me his or her strategy was going to underperform their benchmark over time. And yet, report after report shows that even after adjusting for the most appropriate blended average benchmark, many do just that.
Given that, perhaps you've decided that you prefer active management over indexing. But how do you pick those managers?
In a recent newsletter, John West of Research Affiliates LLC indicated that it would take roughly 35 years before you could statistically identify outperformance due to skill as opposed to luck. (Disclosure: I used to work for a index fund manufacturer that had a business relationship with Research Affiliates.)
The notion that outperformance can be mistaken for skill has been raised before.
Two U.S. professors, Eugene Fama and Kenneth French, looked at the distribution of alpha estimates for active funds in the U.S. and compared them to a distribution expected by chance, assuming that true alpha is zero, or in plain English, that no outperformance due to skill exists. They found that the two distributions were similar enough that many funds perceived to be helmed by a skilled manager could not reliably be distinguished from a fund run by someone who was just lucky.
It's worth noting that they also found that all funds put together look pretty close to the index, so if there are more fees to pay and higher tax drag due to higher turnover versus an index portfolio, then this naturally translates into lower returns to investors.
We can learn a lot from that.
What's the point in holding a portfolio that looks a lot like the index if you're not paying index fund fees? These funds are typically known as closet index funds because they aren't sold as index funds, but rather as active funds which command higher fees. It seems pretty clear to me that if you are going the active management route, one solution is to look for funds that are significantly different from the index makeup.
If it's not different from the index, why would you expect better returns than the index?
Preet Banerjee, B.Sc, FMA, DMS, FCSI is a W Network Money Expert. You can follow him on twitter at @PreetBanerjee