Once you've determined the asset allocation that is best for you, you have to implement it via the investments you choose for your portfolio. At the most basic level, there are two types of financial risk. When you decide to invest in a broad asset class (e.g., U.S. equities, or Australian bonds), you take on "beta risk". This is variability in returns that is associated with the asset class as a whole. The return on a mutual or exchange traded fund which tracks a broad asset class index compensates you for taking beta risk. The only way to reduce your beta risk is to diversify your investments across more than one asset class. Index investing is all about managing your exposure to beta risk.
In addition to being compensated for your portfolio's exposure to beta risk, you may also choose to pursue higher returns by taking on "alpha risk" that is associated with individual securities and groups of securities within an asset class. Unfortunately, the return for bearing alpha risk is ultimately a zero sum game. Within an asset class, the positive and negative returns associated with the alpha risk on different securities cancel each other out, leaving only the return for bearing beta risk. Taking on alpha risk is known as active investing.
Should you be an active investor? To begin with, active managers start off with three big disadvantages compared to index funds. First, because of the costs associated with obtaining and analyzing information to identify attractive investments, active management is more expensive than indexing. Second, because active managers tend to trade more often than indexers, they also incur higher transaction costs (e.g., commissions and bid/ask spreads on their trades). Third, when active managers realize a profit by selling an investment, they also trigger tax payments. Because index funds trade less often, they generate lower taxes for investors.
Consistently successful active management (i.e., active management that delivers higher returns than those on an index fund, after expenses, trading costs and taxes) fundamentally comes down to successful forecasting. And successful forecasting is ultimately based on either superior information and/or the use of a superior model. Superior information can take the form of either private information that other investors don't have access to, or public information that reaches you before it reaches most other investors. Before regulators clamped down (e.g., the U.S. Security and Exchange Commission's Regulation FD), companies selectively made a lot more private information available to investors than they do today. Moreover, the internet has given all investors much faster access to information than before. In sum, delivering consistent active management success based on a constant flow of superior information seems to be a very difficult challenge to meet. It is easy to understand why this is so. Think of any professional sport, where the best athlete's in the world compete against each other. How many players, or teams, come out on top year after year? Not many. In fact, so few are able to do this that we hold them up as legends or heroes. When you are competing against the best players in the world to obtain superior information, coming out on top in one year is possible; doing it consistently over a ten or twenty-year period is next to impossible.
Of course, that leaves a superior forecasting model as a possible basis of consistently successful active management. Unfortunately, the insight provided by models seems to have a relatively short half-life. First, given the amount of computing and intellectual horsepower deployed by active managers, successful models don't remain undiscovered by others for long. And once they are discovered, their benefits get rapidly competed away. Second, the underlying dynamics of the real economy and the financial markets are themselves constantly changing, which tends to quickly invalidate some of the assumptions on which previously successful models are based.
Finally, it doesn’t help to say "but I'm hiring a fund manager for that." All this line of argument does is raise the forecasting challenge to another level: what is the basis for believing you have superior skill when it comes to forecasting future manager performance? Or in choosing a superior consultant or financial adviser who will select those superior active managers for you? We don't deny that with hindsight, a very small number of active managers turn out to have delivered consistently superior performance on the basis of skill and not luck. We just don't know how to reliably identify them in advance. It's a lot easier to identify Warren Buffett than it is to identify his successor, much less entrust a substantial portion of your assets to him or her.
In sum, there is only one argument that logically leads you to the conclusion that actively managed funds make sense: "Some active managers will, due to their manager's skill, outperform index funds (after expenses, trading costs, and taxes) over the medium and long term. Because of either superior information or a superior forecasting model, I (or the advisor I trust to do this) can identify these managers in advance. Therefore, the prudent course of action is to invest my savings with these active managers." That’s what it comes down to. And if this argument does not apply to you, then the prudent course of action is to invest your savings in a diversified portfolio of asset class index funds.
Now, let's move on to Retired Investor's discussion relating to the separation of Alpha and Beta: Portable Alpha.