The common sense on mutual funds, especially as promoted by Bogle, founder of Vanguard index funds, is that investing in actively managed mutual funds is a loser's game over the long run. The statistic that is most often quoted in this regard is that over time, 80% of actively managed funds lag the simple S&P 500 index, with dividends reinvested. Add to that the fees associated with actively managed funds compared with the very low cost of index tracking funds, you have a recipe for losing out 1-2% every year, which will take away a sizable chunk of your portfolio over time.

There is a lot of appeal to this very simple approach. Adding a bit of diversification to your portfolio by adding different kinds of indices - bond index, real estate index, international stock market indices (both industrialized and emerging), commodity index and the US stock market index - would provide you with solid returns at a low cost as well as help your portfolio ride out the ups and downs of various markets.

We are proponents of this approach, even though indices in some of the other markets are not quite as efficient as the one for the main US stock market indices (Dow Jones, S&P 500 and Wilshire). The only approach that is superior to a pure index driven approach is where the concentration is on value. Small cap value stocks tend to outperform the markets in both bear and bull markets when viewed over a 5 year or longer period. Large cap value stocks both domestically and internationally are to be viewed favorably for superior long term returns.

In general, value stocks have a better chance of adding that extra return above the market since they are, by definition, undervalued, and thus under-represented in the index's overall value. A similar argument could be made for growth stocks, but because of the excitement associated with growth, these stocks quickly reach overvaluation and stay there, even if the company continues to outperform. This reduces the margin of safety in growth stocks, and makes most mutual funds which climbed on the bandwagon late, show up as laggards.

A second approach to succeed with actively managed mutual funds is to invest in mutual fund managers. Managers with great track records and well-known investment styles, who understand the companies and industries they invest in. Managers such as Bill Gross of PIMCO, Bill Miller of Legg Mason, Warren Buffett of Berkshire Hathaway (which is not a mutual fund, but is a holding company) and so forth.

A third approach, though more risky, is to determine which sectors of the economy are in a major, secular bull market and invest in those sector specific mutual funds. With this you should apportion only a small part of your portfolio to these funds, since they will not provide you with the diversification you should have. But if you have correctly identified a major secular bull market, these sector specific funds will make you a lot of money and keep your portfolio well ahead of the market.

Finally, you could put a part of your portfolio in individual stocks, while keeping the majority in index funds. With the help of some of the best investment newsletters in the business, this part of your portfolio could be used to accelerate your returns to above average and this keep your portfolio gains ahead of the market returns.