Some investors read news like this and say, “Sure, there are plenty of mediocre active managers, but I'll pick the best ones!” After all, there are several national magazines that publish annual “Top Mutual Fund” lists. It's logical to think that you can do better than average if you just use the best funds, right?
The problem with this is something called “persistence.” Most “top” managers simply don't have the ability to reproduce prior results. According to Srikant Dash, Index Strategist at Standard & Poor's, “research suggests that screening for top-quartile funds, as the sole basis for an investment decision, is inappropriate. Very few funds repeat a top-quartile performance. Furthermore, Standard & Poor’s research shows that a healthy percentage, and in most cases a majority, of top-quartile funds in the future will most likely come from the ranks of prior period second and third quartiles."
Holy cow. You mean I should pick the mutual fund managers that had mediocre performance in the past, because they are more likely to outperform in the future? Well, not quite. That would truly be a shot in the dark. The real point here is that it's very difficult for active managers to beat their benchmarks.
I'm not suggesting that active managers can't be exceptional. But what are your chances of determining which managers will have exceptional performance after you invest with them?
The issue of persistence is one more reason it makes sense to be an index investor.