If you listened to the pundits on CNBC or took the mutual fund advertisements in the newspaper at face value, you would be forgiven for believing that a sound retirement strategy is to simply invest your money in top quality mutual funds from a reputable firm such as American Funds or Fidelity.  Then “buy and hold”, invest the dividends, and wait for the markets to appreciate 7% a year for the next 30-40 years.  Even now, with markets at record lows, the tendency is to double down on your current funds.

It is difficult to break this mindset when the investment industry spends over $1B each year on ads and golf sponsorships to convince us to entrust our money to them since they are “professionals” and we are not.

But the evidence suggests otherwise.  Simply put, the #1 reason for the performance of your retirement and brokerage accounts is your asset allocation, not which mutual funds you buy, sell and hold.

As I wrote yesterday, the evidence supporting that low-cost index funds and ETF’s beat actively managed mutual funds is overwhelming.  To be clear: accounting for management fees, we are all better off buying index funds than expensive mutual funds.

So what does account for the performance of professional managers and individual investors alike?  In the definitive study done on the subject of investor returns, well-respected researchers found that it was asset allocation that

…accounts for a little more then all of total return….On average, the pension funds and balanced mutual funds are not adding value above their [asset allocation] policy due to their combination of timing, security selection, management fees, and expenses.

When you, as an individual, put your retirement in the hands of professional mutual fund managers, it means:

…the average investor must underperform the market on a cost-adjusted basis.

What the research shows is that the #1 driver of your investment performance is setting and maintaining a sound asset allocation strategy.  Compared to the time you spend on researching individual stocks and tracking past mutual fund performance or the number of stars Morningstar has bestowed upon your mutual funds, how much time have you spent on your asset allocation?

I have written numerous times here about the overwhelming and consistent evidence showing that investors are far better off owning low-cost index funds rather than the more-expensive, actively managed mutual funds.

This is due to the Holy Trinity of mutual fund investing: 1) most mutual fund managers do not pick stocks that outperform their benchmark, 2) management and 12(b)-1 fees wipe out any gains if they are achieved, and 3) the tax implications for distributions and gains further erode performance.

Yet another study, this one covered in the NYT this Sunday, shows once again that index funds beat either professional alternatives: hedge funds and mutual funds.

Mr. Kritzman found that, net of all expenses, including federal and state taxes for a New York State resident in the highest tax brackets, the winner was the index fund.

Specifically, he assumed that long-term capital gains were subject to a 15 percent federal tax and a 6.85 percent state tax; short-term capital gains and dividends were taxed at a combined federal and state rate of nearly 42 percent. The index fund’s average after-expense return was 8.5 percent a year, versus 8 percent for the actively managed fund and 7.7 percent for the hedge fund.

Expenses were the culprit. For both the actively managed fund and the hedge fund, those expenses more than ate up the large amounts — 3.5 and 9 percentage points a year, respectively — by which they beat the index fund before expenses.

So, you are thinking to yourself, that’s no problem, I’ll just find the best mutual fund managers that beat the markets by more than they charge in expenses.  Um, good luck with that plan.

The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland. Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds.

But even that sobering statistic paints too rosy a picture, the professor said. That’s because it’s one thing to learn, after the fact, that a fund has done that well, and quite another to identify it in advance. Indeed, he said, he has found from his research that only a minority of funds that beat the market in a given year can outperform it the next year as well.

Professor Wermers said he believed that it was “exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone.”

“By definition, therefore, such a fund could not have been identified in advance,” he added.

You can imagine, then, how interested I was to see that none other than the smart folks over at Harvard Management (the group that manages all of Harvard’s money) are almost exclusively using ETF’s to manage a significant chunk of their assets.  As you can see from this table of their federal filings (thanks to Paul Kedrosky for pulling it together) 9 of Harvard’s Top 10 Holdings are low-cost index funds:

How about them apples?

(The only thing I could think of that ties together the elements of surprise, the little guy overcoming the power of the establishment, and Harvard was, naturally,Good Will Hunting)

If you take a step back from the Top 10 and look for trends, you can see that Harvard is not bullish on the prospects for the US markets for the foreseeable future.  It’s all about the rest of the world.  Check them out for your own investment strategy:

1. Emerging Markets (EEM)
2. China (FXI)
3. Brazil (EWZ)
4. South Africa (EZA)
5. Mexico (EWW)
6. U.K. (EWU)
7. India (INP)
8. Russia (RSX)

So, if low-cost index funds and ETF’s ourperform the mutual fund alternatives AND they are favored by savvy, professional investment managers that get PAID millions to manage billions of dollars, you would think they would be good enough for us.