IT'S A COMMONLY USED

explanation of probability and randomness: Take 1,000 chimpanzees, have them flip coins 10 times in a row, and some of them are bound to get heads all 10 times. We consider those chimps lucky.

Take the same idea and apply it to stock-picking. Only now, the primates in question are mutual-fund managers. With so many out there actively running portfolios, some are bound to pick winners. Most of us would call the ones that do talented, but not William Bernstein. The author and investment adviser puts the fortunate managers' performance on par with that of the coin-flipping simians.

Despite endless warnings from financial experts and the fine-print in prospectuses, Bernstein says, investors continue to make the costly mistake of presuming that a fund's past performance is indicative of future returns. It's not. That's why Bernstein, who runs Efficient Frontier, a boutique money-management firm in North Bend, Ore., with $140 million in assets, always favors index funds for long-term investments. While some managers will outperform the market over any given period, he concedes, very rarely do those same managers continue to do so indefinitely.

"Forty to 50 years of data show that it's all due to luck," he says. "The studies show that if you take successful money managers that have done well in the past [and] track them, you see they don't outperform the market."

Bernstein points out that funds that tracks various indexes, whether bonds, domestic equities or foreign stocks, also have the advantages of lower fees and greater tax efficiency. That's generally not the case with actively managed portfolios that involve more turnover of holdings. SmartMoney.com asked Bernstein to elaborate on his belief in indexing and disbelief in some managers' investing skill.

SmartMoney.com: First off, you're a neurologist. How did you get into money management?

William Bernstein: I'm a retired neurologist. The only thing I do with that is teach on a volunteer basis.... The way I got over from neurology to finance is that 15 to 20 years ago, I found myself with money to invest, and I was looking to invest for retirement. I approached it the way scientists approach it, by looking at scientific literature. You look at what the best evidence and best data are. But I found that when physicians invest, they don't do that. They read the New York Times and USA Today. They don't read the Journal of Finance or Financial Analysts Journal. They don't even read the primary textbooks or stuff by Burton Malkiel and [Vanguard founder John] Bogle.... They read the popular press.

I surveyed the primary finance literature by Sharpe, Fama, French and people like that. I realized how important passive investing was, and how important keeping expenses down was, and how important asset allocation was. I started putting together my own asset allocations, and I realized that I had something valuable to small investors. I put together finance literature on my own. I figured out asset allocation on my own. I wrote it up in 1995, which was my first book [titled "The Intelligent Asset Allocator" and published in 1998].

SM: Why do you think it's so impossible to beat the market?

WB: I'm basically someone who's a top-down person. Markets are efficient enough that if you decide you want a certain asset allocation, you decide to invest passively, it's difficult to beat that performance at the market level. Indexes will beat three-quarters of active managers. If you look at a global portfolio, if you actively manage each of 10 asset classes, chances are you'll lose. To win in one asset class, you can be lucky and beat the index. But if you're an investor, you need to beat the benchmark in at least seven or eight of the asset classes if you're investing in 10 to 15 asset classes. The chances of doing that are close to zero.

SM: But people be it mutual-fund managers, hedge-fund managers or ordinary investors find ways to make abnormal returns in the stock market.

WB: Sure, I can show you data on hedge funds and mutual funds that mutual-fund managers have beaten the market. So say there is proof you can beat the market. But that's like saying you didn't wear your seat belt and you didn't have an accident, so you don't need a seat belt. So much of life is due to chance. Mutual-fund managers and hedge-fund managers behave like outperformance isn't due to chance. If it's due to luck, it won't repeat. If it's due to skill, it will repeat. Forty to 50 years of data show that it's all due to luck. The studies show that if you take successful money managers that have done well in the past [and] track them, you see they don't outperform the market.

One of the studies looked in given five-year periods at what were the best mutual funds, and tracked how they did going forward. In each and every case they underperformed the Wilshire 5000 Index. In a couple of examples they did better than the average mutual fund, and in a couple of examples they did worse than the average mutual fund. So they did average. But the average mutual fund is terrible. You're also paying transactional expenses, the hidden costs of doing transactions. The average mutual fund gets the market return minus their expenses. You're much better off getting market return. As John Bogle says, it's simple arithmetic. You keep expenses down by investing passively.

SM: Are you against all forms of active investing? Even exchange-traded funds?

WB: I'm not totally against active investing. I think if you diversify properly, it's OK to invest actively... There's nothing wrong with ETFs; they're basically index funds. I have no problem with ETFs. The average Vanguard plain-vanilla index fund is probably slightly better than the average ETF. If I had to grade these, the average Vanguard index fund is an A. The average ETF is an A-. The average mutual fund is a C. And a managed brokerage account is an F.

I liken an ETF to a chain saw. It can be very powerful if used correctly and appropriately. It will slice your arm right off if you use it improperly. Which means: If you're speculating, buying at 2 p.m. one day and selling the next week, if you try to follow trends, you're going to get your wealth amputated.

SM: What's an appropriate asset allocation?

WB: I agree with Bogle that bond allocation should be appropriate for your age. If you're 50 years old, you should have 50-50 in bonds and stocks.... The next question would be what do you invest in bonds and stocks? Bonds should be corporate Treasurys, somewhere between one- and five-year duration. The Vanguard Short-Term Bond Index fund is a superb fund. It doesn't get any more cheap or efficient than that.

With stocks, I say domestic with a value tilt. You should have some small stocks in there, like one of Vanguard's small index funds. And for large stocks, an S&P 500 index fund. And then as far as foreign funds go, Vanguard has a total foreign stock fund, and a Pacific and European fund if you want to break it down. One thing about Vanguard is that it doesn't have a good foreign value fund. That's the one case I'd recommend an ETF. Barclays has an ETF that's the value half of the EAFE index. You want to have value exposure.

In my two books I've recommended asset allocations. It's important to know one size doesn't fit all. A taxable portfolio is different from someone investing in IRAs. A good example is [real-estate investment trusts]. The income on REITs is all taxable, so not very tax efficient. Value stocks tend not to be as tax efficient. All of the recommendations I've made I believe still stand with one exception: instead of using Vanguard International Value fund, use the Barclays ETF [iShares MSCI EAFE Value Index fund].

SM: The name of your company, Efficient Frontier, refers to optimal portfolios plotted along a curve that have the highest expected return possible for the given amount of risk. How does this financial concept relate to your recommendations?

WB: The Efficient Frontier name of my company is almost a sardonic title. Efficient Frontier refers to that portfolio which produces the highest return for a certain degree of risk; portfolios that have the lowest degree of risk for a given return... It sounds wonderful, but you can't get there from here. In order to get to the efficient frontier you have to know the future expected return of an investment, and you can't know that. So I might as well have named the site the holy grail of investing. It's like heaven; it's a nice place, but you can't get there...

If I had to have one investment motto, it would be you can't violate the law of gravity for very long. There are no bad asset classes. If you see an asset class that's been doing awfully, more than likely it's underpriced and will do well. If one asset class is doing really well in the last 10 to 15 years, chances are it's probably going to go down. That's what happened to the S&P 500 index in the 1990s. Everyone said American large-cap stocks were going to take over the world, and that was the only place you should invest your money. I was puzzled by this. It was the exact opposite of what we heard for the past 70 years...

One overarching concept that I think is useful is how much noise there is in finance. You could take the dumbest, most inept, incompetent money manager, and without a great deal of luck he can beat the market over 10 years. If you're a terrible money manager you can beat the market. On other hand, you can be the best money manager, have the best information, the best discipline, and with a little bit of bad luck you can underperform the market for 10 or 15 years. When you see someone beat the market, it's probably because of dumb luck.