Fund managers, through either luck or skill, will at times successfully pick stocks that could beat the markets, but few can consistently do this. Does this necessarily mean that it’s better to track an index with exchange traded funds (ETFs) instead?

Evidence has shown that passive investing in index funds tends to beat more than half of the active managers in most years, remarks Michael Schmidt for Yahoo! Finance. This just goes to show that managers usually don’t pick stocks effectively enough to justify the fees.

The average manager is pressured to perform well while being saddled with management fees, transaction costs to trade and the need to hold cash weightings. If all the costs were removed, the performance of the general index compared to the manager is probably much closer.

Stock picking by fund managers can come into question when considering the efficient market hypothesis (EMH). EMH implies that the market participants are well informed and act on available information and securities are then appropriately priced based on everyone’s understanding of the market. But stock picking gives the idea that there are some who are able to consistently outperform the market by exploiting information that is not fully reflected in the price of a security.

In reality, markets are inefficient. Investors each have a unique investment style and unique ways of evaluating market picks. Someone may lean toward technical strategies while another relies on fundamentals, or others could rely solely on lady luck. Emotions, rumors, price of securities, and supply and demand are all changing facets of a market. As such, information may also not be fully disseminated equally.

What’s the solution?

1. Instead of stock-picking, utilize ETFs to accomplish your goals. They offer diversification and transparency at a lower cost than most mutual funds.

2. Try an easy-to-implement strategy, such as trend following. Relying on the markets to be efficient or using a buy-and-hold strategy may no longer work as well in the future.

Max Chen contributed to this article.

Tags: ETF 101, Trend Following