Traditional managed funds are one of the world's great disappointments, at least in terms of meeting their stated objectives of beating performance benchmarks after costs (though many funds today promise to beat the benchmark before costs, which seems quite pointless). The trouble with actively managed funds is that they are generally too diversified to add a meaningful amount of extra value over their benchmark indexes and too expensive in terms of fees and other costs to convert what additional performance they do generate into higher after-fee returns for investors. The continuing popularity of managed funds is more about the triumph of hope and marketing over experience than anything else.

I favour low cost index funds over active funds because:

• actively managed funds consistently fail to beat passive index funds. The experience in America, where such funds have been around for quite a while, is that they beat around 75% of all actively managed funds over the course of a decade. Over the course of more than a decade even fewer active funds beat the index trackers.
• there is no completely reliable way to know in advance which managers will beat their relevant indexes. Studies have found weak correlations that sometimes enable investors to choose above average funds, but these strategies still don't produce returns higher than index trackers. Beating the median manager is not a particularly useful achievement when the median manager usually lags behind the indexes by a fairly significant margin.
• active funds change their staff and strategies often enough that even a superior manager will rarely remain in business for long, there is a significant "style drift" in managed funds, so even a virtually perfect fund today could well degenerate into absolute rubbish next year.
• most active funds focus on quarterly performance benchmarking and generally adopt aggressive short term investment strategies that result in high turnover, high costs, high risk and poor long term performance, all in the name of not wanting to fall behind the other managers over any short term period.
• index funds are usually far more diversified than active funds, so they are lower in risk.
• fees charged by active funds are significantly higher than fees for index funds.
• index funds are usually more tax efficient than actively managed funds, due to lower turnover.
• index funds are a low maintenance investment, they don't change their investment strategy over time and so can be purchased and literally held for ever. You virtually can't go wrong by choosing a low cost index fund with a reputable index fund manager.

Do I use any active funds at all? Yes, in addition to an indexed "core", but usually not the mass marketed ones most members of the public buy. If I am going to use an active fund I look for combinations of the following atributes:

• low fees, or a combination of a low basic fee and a performance fee for beating the benchmark.
• low turnover. This excludes more than 90% of active funds, if funds trade too much they are unlikely to have good long term performance and their tax efficiency will be low. I prefer funds to hold stocks for years, not days or months.
• a highly disciplined value strategy, consistently applied without thought of short term underperformance. Value stocks (stocks that are trading at low prices) have been shown over time to perform better than the broader indexes. Most active value funds squander this performance advantage with their fees, trading and emphasis on short term performance.
• an aggressive approach to investment. The purpose of buying an active manager is to benefit from their analysis skills. You won't get much benefit if they are going to be a quasi index fund with high fees and turnover. I am looking for drastic weightings changes compared to benchmarks, a reasonably concentrated portfolio, a willingness to buy heavily discounted value stocks and possibly a willingness to short sell as well as take traditional "long" positions.
• is preferably a smaller fund manager, because it is a proven fact that larger funds are more difficult and expensive to manage and significantly less likely to beat the benchmark index.
• the fund has an excellent long term performance, but ideally is presently lagging the index due to a general downturn in value stocks as a sector. All things being equal, a very bad short term performance can be a very good buying opportunity for investors. All things move in cycles, and value stocks move in and out of favour. It is far better to buy a quality value fund when they are lagging than when they are booming.
• good people. I am looking for highly respected managers with a good track record managing this fund or previous funds. I also want to see stable and contented support teams. Staff turnover is a problem for active funds, so I want some assurance that the star manager is not going to be poached by someone else any time soon. Another factor I particularly like to see is the managers of the fund put a significant amount of their own personal wealth into their own funds. I particularly like to see funds where they combine a performance fee system (they get paid more if they outperform) with large personal investments in their own fund (so at the same time managers have an incentive to be careful), several funds I use are like that and they just happen to be among the best performing funds in the country!

My strategy for choosing active funds is not just about performance, it is about diversification as well. Some (not many) active funds are so different to indexes that they perform like they are part of a whole different asset class. Buying these funds can lower your overall portfolio volatility because they don't move strictly in line with indexes. There is no point paying an active manager to perform in a very similar manner to the indexes, because the best fund to do that is a proper index tracker. Buying a long/short value fund for example can be a great strategy when the market appears expensive because they can make good profits in a falling market. (Many of the funds I use made a small fortune out of the "tech wreck", short selling tech stocks.)

In addition, active funds can sometimes capture a niche asset class that I might want to gain exposure to even though there are no index funds available. A low turnover and low cost active manager can be an alternative to a specialised index fund if there is no other choice.

I mainly use these active funds for the most aggressive investors. For conservative investors an index fund is usually a much better choice due to the extensive diversification, low risk and low costs of these funds. I also tend to use active funds more in superannuation investments, where taxes are lower and hence the higher portfolio turnover won't hurt as much.

My favourite funds tend to have a low basic management fee in addition to charging a performance based fee. Some funds do have high performance and they do manage over long periods of time to sustain index beating returns. If fund managers have enough confidence in their own abilities that they are willing to charge a very small basic fee and charge the rest only if they manage to deliver performance well above their benchmark then I consider that to be a strong statement. Many active funds don't charge a performance fee though, they charge a single high fee, often around 2%pa, regardless of how well they perform.

Most investors think that the purpose of a financial adviser is to find someone that will choose the highest performing funds or stocks, or to find someone that will pick market tops and bottoms to help clients time entries into the market.

As for selecting the best funds, I look at funds paying attention to the factors I mentioned above. That said, I make no special claim to be able to select top performing funds in advance. I believe my system makes perfect sense and should produce excellent results, but the core of my strategy is still asset allocation and cost minimisation.

Anyone claiming to have the ability to time the market with any consistent success is a fraud. As John Bogle, Chairman of the Vanguard Group, one of the world's largest fund managers once said of market timing, "I don't know anyone who's ever got it right. In fact, I don't know anyone who knows anyone who's ever got it right."

One academic and industry study after another has confirmed the thesis: if you try to out-guess the market, your success or failure will be a matter of luck. Consistent outperformance of market benchmarks is almost never seen.

The job of a professional adviser is not to help with timing markets, but to formulate an appropriate strategy that will generate consistently good returns by managing risk and return with appropriate asset allocation.

My task is to select appropriate funds (mostly index funds), and an appropriate mix of these funds to suit a client's own needs. Funds are selected on the basis of fees, strategy mix and diversification mix.

For more aggressive investors, I usually recommend gearing into indexed portfolios rather than trying to pick high performance funds.

There are a few ways that an adviser can control performance. While fund picking is a frequently fruitless exercise, advisers can make a difference with:

• the relative mix of shares, property, hedge funds, bonds, cash and other assets.
• the balance of "value" stocks to "growth" stocks.
• the frequency of portfolio rebalancing (more often is not necessarily better).
• selecting investment products with low fees.
• the amount of fund switching, or turnover.
• the amount of gearing.
• educating clients so together we can implement better and more sophisticated strategies.

Generally I do not enter into timing decisions, but for those wanting more proactive management of the portfolio in the name of trying to improve the return I do vary my asset allocations slightly in line with a strategy called "contrarian asset allocation" and recommend an investment strategy called "value averaging". You can read all about these strategies in the portfolios section of my investment FAQ.

The major features of my approach:

• Primary focus on portfolio construction, exposure to asset classes via passive index funds where possible.
• Seek lowest cost approaches, low fee investments and portfolio management services.
• Long term "buy and hold" strategy, with rebalancing.
• Minimise portfolio turnover, and manage taxes where possible.
• Continued research and study of the latest developments in asset allocation and portfolio theory.
• Manage risk and return with portfolio tilts. For example, a more aggressive investor with a desire for better returns might tilt the portfolio away from the standard index funds, into passive funds following "value", emerging markets and small company strategies.

Click here to download investment.ppt, a Powerpoint presentation that gives a bit more background to my investment strategy.