It’s been another poor year for active managers across the seven key equity sectors monitored by AJ Bell’s Manager versus Machine report. Overall, just 36% of active managers outperformed the average passive alternative in 2023.

One year is too short a time frame over which to judge the success of active management, but things don’t look better if you zoom out a bit either. Over 10 years, just 32% of active managers have beaten the passive machines.

It’s little wonder that many investors are plumping for trackers over active strategies. Over the last five years £9 billion has been withdrawn from active funds by UK retail investors, and that compares to £75 billion going into passive funds, based on Investment Association data.

There are some mitigating factors which may help to spare some of the blushes of active managers. Much of the weak overall showing comes down to the performance of active funds in the popular global sector.

Here only a quarter of active funds have managed to beat a passive alternative over the last 10 years. This is in part due to the fact that the winning stocks in the global market have generally been a clutch of large technology companies.

HARD TO KEEP UP

While active managers are of course free to invest in these stocks, and many have, actually investing more than a passive fund means taking a pretty big bet. For example, a typical global tracker fund currently holds around 5% in each of Apple (AAPL:NASDAQ) and Microsoft (MSFT:NASDAQ).

That’s more than in the whole UK stock market, which currently makes up just over 4% of the MSCI World Index. Active managers may baulk at holding more than this in just one stock within a globally diversified portfolio.

Amongst UK equity funds, another crucial market, there have also been some structural trends which have dented the performance of active managers. Mid and small caps have underperformed their large cap cousins in the last two years, which has been to the detriment of active managers, who tend to hunt down the cap scale for more covert investment opportunities.

Over the longer term mid and small cap exposure has been a tailwind for active managers plying their trade in UK shares, but the current climate is favouring the blue chips, for now.

It’s easy to decry the skill of active managers when it transpires that under a third have beaten a passive alternative over 10 years, but we do have to take into account the market context too, as it may simply be that active managers are just on a bad run. It’s also important to set appropriate expectations when looking at a wide universe of active managers.

The reality is that while all active fund investors expect outperformance, it’s not statistically possible for all managers to outperform. Investors therefore need to pick their battles wisely, by acknowledging that some markets have proved more difficult to beat than others, and by selecting active fund managers in whom they have a high degree of conviction.

A long and successful track record suggests outperformance has been achieved by skill and not just luck, but it’s still no guarantee for the future, so any active portfolio should include several managers for diversification.

Even if you favour a passive approach, there are some areas of the market which are not well served by passive vehicles, or which generally favour an active hand on the tiller, such as producing income, preserving capital or investing in small caps.

Investors can of course blend both active and passive strategies as they see fit, rather than choosing just one approach for their whole portfolio. While at an aggregate level, there are questions over the benefits of active management, there are some active managers who have undoubtedly added value over a long time frame.

By engaging in some judicious fund selection, investors in active funds also help to tilt the odds in their favour.

DISCLAIMER: AJ Bell owns Shares magazine. The editor (Tom Sieber) and author (Laith Khalaf) of this article own shares in AJ Bell.

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