Much virtual ink has been spilled on how difficult it is for individual, and even professional, investors to generate alpha in the capital markets. Ray Dalio of Bridgewater Associates the largest hedge fund operator in the world said as much this week at the Dealbook conference:

“I think the most important thing for an investor is to create a proper balance of those investments,” he said. “In other words, I think that going forward, most investors are not going to be able to produce alpha,” a measure of outperformance.

“Alpha is a zero sum. We have 1,500 people who work there with computers doing all sorts of work and it’s the pros against that,” Dalio said. “I would say most investors should hold a balanced portfolio against that.”

Advice that has been repeated on the blog and in my book repeatedly. James Altucher goes even farther. In a recent post he noted that only three types of players in the financial market make money, one of which involves illegal activity. Aside from buying (good) stocks and holding them forever James believes the only way to truly generate alpha is to:

The only way to make money is to deliver value to people. Don’t try to get rich playing a fool’s game.

Apparently Meredith Whitney did not get either of these memos. According to reports in marketing her new hedge fund she anticipates generating “12-17%” annual returns which one assumes would be after a standard 2 and 20% fee structure. In a world of 0% short term interest rates that is indeed a high hurdle.

The idea that generating alpha is a tough one has become the dominant theme for those writing about the markets for individual investors. Just today Steven Rattner has a piece up that perfectly captures this meme:

Fortunately, Mr. Fama’s work on efficient markets did a favor for the small investor: it spawned low-cost index funds that replicate market averages.

That’s where the nonexpert should park his money. Of course, decisions have to be made about how much cash to hold and whether to own some bonds.

By all means, make those decisions. But as the commercials say, when it comes to active investing, “don’t try this at home.”

Indeed the indexing revolution which have argued has been brought into the mainstream by the introduction of ETFs has been an unmitigated boon for individual investors. Investors today can create globally diversified indexed portfolios for costs that are asymptotically approaching 0.00%. For the vast majority of investors this represents the best way to invest given the relatively low time burden it imposes on the investor.

That being said we are all ultimately need to tailor our own portfolios to our own interests and goals. That is why I liked so much the phrase “Benchmark of You” that Ari Weinberg talks about in this recent article. Just because an all-index portfolio makes sense for most people does not mean you should somehow feel cowed from moving beyond index funds.

One of the biggest proponents of indexing, Rick Ferri, has a post up talking about why for muni bonds, high yield bonds and equity value it may make sense to move beyond index funds. Ferri notes four conditions why this may be the case:

  1. The absence of a diversified low-cost index fund or ETF that tracks the asset class.
  2. An active fund is lower in cost than an equally diversified index fund.
  3. An active fund has greater diversification than an index product, even if the fee is slightly more.
  4. The unique risk I am trying to capture is better suited to active management than in an index-tracking product.

John Rekenthaler talking about the narrowing spread between the best and worst fund managers still sees some opportunity for active managers under certain circumstances:

(T)he upshot is that active managers may indeed be the best option in less-traveled investment areas–but they will need to be kept under close watch. Almost never will they be worth paying above-average expenses. Cost control is the number one investor task, with manager identification being an important secondary job, but nonetheless secondary.

The financial media not one for subtlety. The indexing=good, active=bad meme is the dominant one at present. There are some very good reasons why investors may want to try to take advantage of actively managed funds in select sectors. Provided you have the right framework and expectations this can make perfect sense. However as noted above investors should keep a keen eye on costs and recognize that we are talking about the slices of the portfolio pie, not the whole pie.

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