Can a managed fund produce alpha?

That question has provided plenty of room for debate over the last decade is whether or not a managed fund can really produce alpha for an investor. Of course, up until about 10 years ago, there wasn't much of an alternative to managed funds, but nowadays there are enough low-cost index funds and low-cost ETFs to make your head spin. So given the choice for a low-cost index fund or a managed fund, which direction should you go?

First of all, I do think it is possible to beat the market. Just look at the numbers. Plenty of fund managers cream the market every year -- especially in years like 2008 and 2009. But as I was thinking about this today, I kept coming back to 3 basic reasons I still gravitate toward the low costs index funds.

Challenge #1: Pre-identifying the Manager
Sure, everyone can look at Warren Buffet now and say, "If only I had put $1000 with him in the 60's!" But would you have? There are plenty of smart, young money managers just getting started that would love to take your money now. But it is impossible to know which 1 out of 10,000 is going to be the next Buffet.

Challenge #2: Performance Net of Fees
The next challenge is once you have found a manager that you believe can beat the market over time, you must then deduct fees. (If you check annualized numbers in a prospectus, they should already be net of fees.) If a manager can beat the market by 1-2% every year, but charges a total expense ratio of 1.5%, you really aren't getting ahead.

Challenge #3: Keeping Up Peformance, When the Money Rolls In
The third challenge is the kicker. Let's say that you accomplish numbers 1 and 2 and believe you have found a solid manager with reasonable fees who can beat the market over time. Chances are you aren't the only one who feels that way. For example, his fund may get a 5-star Morningstar rating which sends the cash pouring in. In a closed-fund environment, managers don't have to deal with the constant cash flows in and out of the fund. This means they have to constantly be pouring money into new investments, or if they have the patience to wait for a deal in the market, then their overall portfolio numbers may suffer because of an increased percentage of cash sitting on the sidelines. The flip-side of this coin is also true. When the market goes through a rough patch, and millions of investors panic and pull their money out of the fund, the manager may be forced to sell even if he doesn't want to. In both of these scenarios, the manager who may otherwise have stellar performance, sees his performance take a beating.

There are (at least) two potential answers to this problem.
The first is that you, the investor, become the money manager. Investing in the education, the technology, and time that it takes to be a solid money manager. For most people this is not doable -- as the time and education needed for this FAR outweighs any potential gains.

The second is that you can roll with the market. By building a diversified portfolio that covers both stocks and bonds, domestic and international, you can build a portfolio that suits your needs. If you don't feel comfortable doing this (as you probably shouldn't), finding a fee-only financial planner (check Napfa.org for a fee-only planner near you) who works on a per hour basis is well worth the money. A few hundred or a thousand dollars now for unbiased advice will save you stomach ulcers for years to come.

Thoughts? Leave feedback below.