Index funds will almost always outperform actively managed funds. They are the best choice for the layman investor. An excellent book on this topic is The Little Book of Common Sense Investing by John Bogle.
"Index funds will almost always outperform actively managed funds."
Convenient investment vehicles should not stop you thinking. Index ETF were a great idea. But now everybody is pouring tons of money into them. Not sure this is a good idea, at least not on the scale how it is currently done. A stock is priced by supply and demand. There are stocks where there is basically very little real trading. Only ETF and some HFT funds. Yet, the stock is rising with the index. What happens in a downturn? What happens if this stock drops significantly more? Every ETF has to re-balance to reflect this fact, easily leading to a feed-back effect.
Index funds have to outperform active funds and traders in aggregate by definition. It's not a claim or debate, it's simple math. After savings on taxes and expenses, indexes represent the average + a fair bit more than other options. There is no feedback effect, except that more people indexing will lead to more trading arbitrage opportunities, which people will take and which doesn't hurt indexers, who will continue to take the market average return plus what they save in expenses and taxes. As an aside: the last place to get financial advice is Zero Hedge. Try this instead:
This is true in aggregate, with the additional caveat of over an asymptotically long timeline. Part of the goal of hedge funds, or at least some, is to hedge investments so that you might not get hurt as hard during a recession as the market.
There can still be active funds that perform better than the market, or the market as measured by an index ETF. Unfortunately with the way funds are marketed, funds can often just employ survivorship bias so that all funds look very good. Also, index funds do not have to outperform active funds/traders by definition, because not only can active funds invest in assets outside of the index (other stocks, real estate, futures, options, etc.), but active funds can also have more profitable allocations. Obvious proof: if the value of every stock in the S&P 500 were now worth 0, active funds wouldn't, ergo active funds will not necessarily always be outperformed by indexes.
I think that for your average investor, indexes are the way to go at the moment, but it's not impossible for there to be a world where active funds are often better.
>This is true in aggregate, with the additional caveat of over an asymptotically long timeline.
This is true over any timespan. At any point in time the active part of the market holds the same stocks as the passive part of the market and thus has the exact same risk and returns. This is as true over a century as it is over a month.
>not only can active funds invest in assets outside of the index (other stocks, real estate, futures, options, etc.), but active funds can also have more profitable allocations
If your active fund is investing in different markets then it's not comparable to the index. If there's an advantage in investing in those assets the solution isn't to buy the active fund. The solution is to find the index funds that will also give you exposure to the same assets and buy those instead gaining the same advantage of the same returns with less fees.
>> Every ETF has to re-balance to reflect this fact,
Only market-cap weighted ones. And we are quickly moving away from such things with non-standard weightings and soon to be released actively managed ETFs.
Why do you think this is true? I agree that index funds are better for the average consumer at the moment, but I don't think that means they will always outperform actively managed funds. There are some theoretical benefits of an actively managed fund, as compared to an S&P 500 ETF (although these will largely be true of any index fund; also consider point 0: that the S&P 500 is "actively managed" by Standard & Poors, see more in [0]):
1. An actively managed fund can make so-called "hedged" investments, or simply "hedges". For example, let's say there are 3 big carriage producers in the S&P500, but there's a lot of hype about this new "automobile" invention. We want to make money regardless of whether automobiles replace carriages. Unfortunately, there are about 20 different automobile companies vying for control over the industry, and only one of these is currently in the S&P 500. A hedge fund can spread investments between these companies so that, if/when an automobile company gets big, you're not overly exposed to the soon-to-be defunct carriage industry. Sure, the S&P is in some ways self-hedging since competitors will often both be included in the index, but it's ideally hedged for most things.
This may not be as much of a concern if you are simply looking to maximize returns over an indefinitely long time. But there are a lot of people looking for investment strategies that are less risky than the stock market as a whole: for example, people that are planning on retiring within the next 10 years.
2. Stocks don't always do well in every circumstance. How happy would you be if you invested in a Nikkei ETF 10-15 years ago? Sure there were troughs during then, just as there were in the S&P during that time, but you'll notice that even over relatively long timelines, most people wouldn't make much money from such an index. This leads directly to the next point
3. Hedge funds, to varying degrees, have assets outside of the stock market. These can include bonds (from treasuries which you might buy as an individual, to bonds with higher levels of risk, which you might not), real estate, options, commodities, futures, derivatives. They can also use leverage / trading on margin, which you probably can't/shouldn't. These asset classes provide other ways to hedge investments.
4. Hedge funds have better connections/information/technical ability than the average investor. This means they can talk to CEOs, respond to news faster or even instantly, or do analysis that's too complex for an individual.
I'm familiar with the Boglehead and /r/personalfinance canon, but I think they're focused on steering people away from hedge funds that your broker or "personal wealth advisor" suggest, which may average 6% yoy with a 1% fee. If it were possible for your average joe to invest in DE Shaw or Renaissance, I think that would be the ideal strategy (though, keep in mind that a large part of the reason these hedge funds are able to do so well is their size).
Also, I'm not sure how to prove this technically, but I'm pretty sure that the more the average investor gets invested in index funds, the more opportunity there is for actively managed funds to take advantage of the inefficiencies of the relatively static allocation of an indexed ETF.
1. Diversify into bonds to reduce stock risk and volatility (either a Total Bond or Treasuries fund)
2. Diversify globally to avoid single-country political,
economic and geographical risks (add Total International to balance your domestic stock)
3. If you really want to, buy a commodities ETF to further diversify (generally not recommended at more than 10% of portfolio and not a big deal either way)
4. But we've already seen that after fees they come out behind, so their 'better information' isn't translating into higher returns
The idea that 'too many indexers will kill indexing' has been around for a while and debunked for an equally long time. Here's a source for that:
At the end of the day, there's just no need to get crazy with things. Indexing works. It's reliable. You can sleep at night. I can't really imagine putting my money in the hands of a manager (or set of them). What if they get sick, or bored, or were just lucky early on? No need to add that layer of risk.
"Index funds will almost always outperform actively managed funds."
Convenient investment vehicles should not stop you thinking. Index ETF were a great idea. But now everybody is pouring tons of money into them. Not sure this is a good idea, at least not on the scale how it is currently done. A stock is priced by supply and demand. There are stocks where there is basically very little real trading. Only ETF and some HFT funds. Yet, the stock is rising with the index. What happens in a downturn? What happens if this stock drops significantly more? Every ETF has to re-balance to reflect this fact, easily leading to a feed-back effect.
Some people betting on it: http://www.zerohedge.com/news/2017-04-09/horseman-global-unv...