Some how, index funds have been the stars lately.
Nah, Index funds have been crushing it for decades. There are very few actively managed funds that can be their indexes over any meaningful period of time.
However, it doesn't make sense to me that an active managed fund can't ditch the companies with poor prospects, over priced, or poor management, then pick those with a value bent and a good chance to beat the market.
Well, that is the trick, isn't it? How do you define "Poor prospects" or "over priced"? Is SDRL going to get hammered in 2015 or is this the perfect buying opportunity? Is AMZN overpriced or is Apple a good buy? Some of it is obvious, like ditching companies that are declaring bankruptcy or have some majorly negative accounting issues or news coming about, but beyond that on the margins, it is hard to tell.
It is much more complicated than that. A variety of factors work against active management. Active managed funds have limitations on what they can invest in depending on how they define their strategy and such. If they say they are domestic, they can't invest in international funds, under any circumstances, no matter how attractive or good the investment.
Actively managed funds can't use margin, which can be helpful depending on market conditions. For example, now would be a fantastic time to borrow on margin as rates are well below 1%. For institutional, it is probably below .5%. There are also other strategies that aren't typically used by actively managed funds, such as covered call writing, but closed end funds DO use them.
Another thing are issues with stupid retail investors that typically surge into funds at the worst time (at the top) forcing fund managers to buy when they should be selling and bail at the worst times (at the bottom) forcing fund managers to sell when they should be buying. Also, fund managers can't be fully invested due to shareholder redemptions, so that is a drag on returns.
Funds also have limitations on what they can invest in, for instance, they typically cant invest more than a certain amount in a fund, AND they don't want to invest more than a certain % of the float on any given day for the sake of liquidity and overall ownership of the company.
For example, they may not be able to invest more than say 2% of the overall fund assets in any specific stock. For a 1B fund, that is 20M. They also don't want to invest more than 5% of the overall float, which may be 50% of say a 1B company or 5% of 500M, so they COULD invest 25M, but they can't due to fund policies. Now, just do that 49 more times. Is a 2% going to move the NAV of the fund substantially? Not really.
Then you consider as the fund grows and grows, these numbers still remain and it becomes more difficult to invest in anything that is going that isn't a huge traditional blue chip company. They can't invest a substantial amount of money into smaller companies that are going to deliver the higher returns, which are typically smaller companies due to their self-imposed restrictions.
In Peter Lynch's book one up on Wall St, he goes into detail about the difficulties in investing as a fund manager.
Buffet/Munger do it, are they not normal?
No, they aren't. They are multi-billionaires and they aren't fund managers. Soros has beaten the market for years, but he was a billionaire like 30+ years ago. He made a billion dollars in a single day in the 60's breaking the bank of England, but that was trading currency, which most mutual funds can't do. They have other investment options and things available to them, like borrowing at sub 1% levels or getting 10-1 margin levels.
Perhaps part of the reason is short term focus of investors, not willing to wait a quarter or two of poor performance while a fund manager picks up on the cheap.
Also true, or consider the wave of redemptions at PIMCO following Bill Gross's departure. Is there anything that has substantially changed about the product mix he was investing in? His strategy was sound the day before he left, but now the day after, sell everything?
