The investment management industry has one goal in mind. How to part you with your hard earned cash. Don't get me wrong there are astute investment managers out there who have in the past delivered alpha. There will be investment managers in the future who will deliver alpha. The problem is your chances of finding them are nil.
Any manager that has already generated alpha will likely be asset constrained. His fund will be closed and you can't get in. Where does that leave you? Not in a very good place since you will be required to identify the next emerging manager and to be quite honest, that's insanely hard. Even those of us with decades of investing experience, masters and PhDs in finance who know what to ask and how to analyze have significant trouble. Where does that leave the laymen?
Past performance is not a guarantee of future performance and the likelihood that a manager with great past performance over a short time horizon will continue into the future is so low that the great Warren Buffet (page 20) instructed the manager of his wife's trust, once he passes, to put 10% of the funds into T-bills and 90% into a low cost S&P 500 ETF. This is great advice if your universe of investable vehicles are mutual funds, ETFs and the like. Even if you have access to hedge fund managers you are likely ill equipped to begin the analysis necessary to determine if the manager has capacity to generate alpha. Those pesky investment consultants are worthless as well. What's a girl to do?
That's a very difficult question and even Buffet's advice for his wife needs to be taken with a grain of salt since he is advising her on wealth preservation and not growth. I mean if you had $500 million are you really obsessing if you outperform the S&P 500 by 200bp? However, most of the investing public is looking to invest those nickels and dimes at a rate of return that will turn them into 10 and 20 dollar bills. The only thing I can tell you is that active beta management is worthless. If you don't believe me, I'll save you the time and trouble of reading the following research piece.
The bottom line: Of 2,076 actively managed U.S. open-end, domestic equity mutual funds that exist at any time between 1975 and 2006 our decomposition of the population reveals that 75.4% are zero-alpha funds-funds that have managers with some stock-picking ability, but that extract all of the rents generated by these abilities through fees. Further, 24.0% of the funds are unskilled (true α < 0), while only 0.6% are skilled (true α > 0)-the latter being statistically indistinguishable from zero.
One caveat. Without going into a detailed argument of whether or not the Efficient Market Hypothesis is correct, I believe that in highly developed and widely followed markets, the US and European equities e.g., the above analysis is most relevant. It is somewhat less so for the bond market in the US and probably even less relevant for emerging and frontier equity and bond markets. That being said, I still believe in less efficient markets you still only are flipping a coin. I think perhaps only 50% of managers will outperform in these types of markets.
What does this mean for you? If you are paying a manager any significant non-zero fees for tracking an index, you are almost certainly over the long term going to under perform your benchmark. If this is your strategy, do what Buffet wants his wife to do. Invest in the lowest cost ETF of the strategy you wish to place your hard earned cash.