It doesn’t have to be a binary choice between actively-managed and tracker funds
Thursday 04 Aug 2022 Author: Laith Khalaf

In a year when markets have been falling and long-standing trends have gone into reverse, you might have expected active fund managers to perform better than the passive funds that simply track an index.

But AJ Bell’s latest Manager versus Machine report shows that’s not the case. The report analyses the performance of more than 1,000 funds across seven major equity markets, comparing active funds with index tracker funds in the same sectors, and it doesn’t make for pleasant reading for active fund managers.

LESS THAN A THIRD OF ACTIVE FUNDS OUTPERFORM

Less than a third (30%) of active equity funds outperformed a passive alternative in the first half of the year, down from 34% in 2021. Active performance has been particularly miserable in the UK, where only 12% of active funds have outperformed a passive alternative. In large part this comes down to the poor performance of mid-cap and smaller cap companies so far in 2022, compared to the big blue chips.

Active fund managers tend to have a higher exposure to more modestly sized companies compared to tracker funds. In the first half of 2022 the FTSE Small Cap Index fell 15% and the FTSE 250 fell 19%. But the return from the FTSE 100 was much better with just a 1% fall. So it’s easy to see why having a higher exposure to smaller companies cost active managers dearly.

BETTER LONG-TERM PICTURE

The longer-term figures look more positive for active funds, with 45% outperforming a passive alternative over 10 years. That’s less than half of course, and will be flattered by survivorship bias, as poorly performing funds will tend to wind down or be merged into others.

That still suggests that picking an active fund that outperforms has been little more than a coin toss, at best, even over a long time period. So should investors conclude that active managers simply aren’t worth their salt?

Within the investment industry, the active versus passive debate can be pretty polarising. But everyday investors can afford to be pragmatic rather than dogmatic about this issue, and take into account some of the shades of grey in the argument. While the long term numbers might on the face of things suggest that the odds of selecting an active fund that outperforms is close to fifty-fifty, that assumes investors are simply picking funds blind-folded with a pin. In reality, investors can tilt the odds in their favour in a number of ways.

Most investors back fund managers based on their past performance record. The longer the track record of outperformance, the more compelling the case that the fund manager has exercised skill in selecting stocks. If a fund manager has beaten the market over 10 years, it’s hard to argue they have simply been enjoying a streak of good luck. Of course, that doesn’t guarantee future outperformance, because a fund manager can go off the boil, or may find that the market turns against their particular style of investing.



NOT A UNIFORM PICTURE

But if you can build a balanced portfolio of active managers who have demonstrated skill in the past, your chance of achieving outperformance going forward is much better than a coin toss.

Investors can also be a bit choosy about the markets where they use active managers. For instance, over the last 10 years, 63% of fund managers investing in UK equities have outperformed a passive alternative, but in the US this falls to 28%. The fact that the success of active managers is not uniform across fund sectors furnishes investors with the opportunity to pick and choose which parts of their portfolio they populate with active and passive strategies.

Investors might therefore happily choose to invest in an active fund in the UK, where active managers have met with a high level of success, but at the same time gain exposure to the US passively, as active managers have found outperformance harder to dig out in this region. It’s also worth acknowledging that there are some areas which are not widely served by passive funds, and so an active approach is needed.

The smaller companies market is a good example, as is income investing. And while there are lots of passive ESG funds out there, some investors may decide they want a specific active fund which aligns more closely with their own ethical preferences.

VETTING FOR QUALITY AND COST

Many fund managers might not like to hear it, but they are like any other profession, there are good and bad examples. You wouldn’t get a builder in to do work on your house without first vetting them for both quality and cost, and the same goes for active fund managers. Of course, if you’re not willing to do a bit of homework to find good active managers, then you have the option of filling your portfolio with index trackers, and that is a perfectly sensible thing to do if you crave the simplicity of passive investing.

Even here though, you do still need to do a bit of legwork, in terms of selecting which markets you wish to gain exposure to, and making sure the passive funds you choose are competitively priced. The cheapest UK stock market tracker has an annual charge of just 0.05% per annum. The most costly UK tracker is over 21 times more expensive, coming in at an annual charge of 1.06%, which will act as a serious drag on the growth passed through to investors. So even when it comes to investing passively, you still need to make some active decisions.


DISCLAIMER: Financial services company AJ Bell referenced in this article owns Shares magazine. Tom Sieber who edited this article owns shares in AJ Bell.

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