Choices, Choices (Part 4)

So how do you find a winning fund?

Active managers often underperform the market in the long run after fees. This happens for lots of reasons. Hot returns are self-defeating.

Economic laws work against active management on many levels. But there are ways for average investors to use them to their advantage. For example, the law of risk and uncertainty—sometimes called the black swan effect—means that you don’t know what you don’t know. This doesn’t just mean bad news: there are “white swans” out there: a cure for cancer or a 100 mpg car.

The most efficient way to profit from these undiscovered inventions is to own the total market. That way, you’re guaranteed be invested in the latest advance. So is indexing the best approach? After all, that’s the cheapest way to invest in everything.

Yes, and no. You want to have the total market. But market weighting means buying more of expensive companies and less of cheap ones. If you can invest in everything but manage your holdings so you own a little less of what’s hot, you can use the law of mean-reversion as well: hot sectors eventually blow up. When they do, you want to be under-weighted.

By investing in a portfolio of global index funds that hold most of everything but that let you assign ideal weights to different sectors, you can often do better than the market even after fees. It’s like running downhill. When the law of gravity is on your side, you just move a little faster.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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