Actively managed funds are generally very much more expensive than passively managed funds. When you include transaction costs, investors often end up paying at least ten times more in fees and charges than they would with an index fund.
In the fourth article in this six-part series on the cost of investing, we ask whether a financial adviser is ever justified in recommending an actively managed fund.
Despite the growing popularity of passive investing, the majority of financial advisers continue to favour actively managed funds. So, are they justified in doing so?
Long-term outperformance is very rare
There can arguably only be one justification for an adviser recommending an active fund; it’s that they genuinely believe it will outperform the market after costs. In truth, however, consistently beating the market over the long term is extremely hard, and only a small proportion of investment professionals manage to do it.
There’ve been numerous studies on this subject, including an ongoing study into the performance of active equity funds in Britain and the US by a team led by David Blake at the Pensions Institute. It found that very few funds beat the market over the long term on a cost- and risk-adjusted basis.
That conclusion is consistent with data regularly produced by S&P Dow Jones. In the ten years to the end of 2017, S&P’s SPIVA analysis shows that the vast majority of UK fund managers failed to beat their benchmarks. In the US equity sector, for instance, fewer than 7% of funds outperformed, and only around 5% in global equities. Active managers in the US have performed even worse. In fact, there’s now SPIVA data available on fund performance all around the world, and the figures are remarkably consistent across different countries and asset classes.
There are some who question the independence of the SPIVA analysis, given that S&P Dow Jones has a foot in the passive investing camp (it primarily generates revenues by licensing the use of its indices to asset managers). But the Active/ Passive Barometer published by Morningstar paints a very similar picture, and Morningstar has no obvious commercial interest in promoting index-based investing.
Why is beating the market so hard?
Why, then, is active management so difficult? Why do so few active managers consistently beat the market? There are three main reasons.
1. Market efficiency
Security prices reflect publicly available information quickly and accurately. At any point in time, prices represent the fairest assessment of value, until more information becomes available. Trying to beat the market is like pitting your wits against millions of traders around the world. The chances that any one fund manager will consistently have valuable insights that other market participants don’t are slim. Even in cases where managers do outperform consistently, distinguishing luck from skill is a real challenge.
2. The zero-sum game
The financial markets are competitive, and most trading nowadays occurs between professional investors. Generally, the reason why an active investor sells a stock is that they think it’s going to perform poorly relative to the market; the stock is bought by another active investor who believes it’s going to perform well. They cannot both be right. One active investor can only win at the expense of another active investor.
3. Costs are a high hurdle
The final reason why so many active managers fail is that just beating the market isn’t enough; they need to beat it by a big enough margin to justify the costs entailed in using them. On average, fund managers will produce average returns, but from those returns you have to subtract what Vanguard founder Jack Bogle used to call “the cost of playing the game”. For the majority of managers, fees and charges are too high a hurdle to overcome.
Identifying outperformers in advance is very difficult
Of course, even though most funds underperform the market in the long run, there is a possibility that the funds you pick will outperform. Realistically though, your chances of identifying a winner, in advance, in every major asset class are small.
Some advisers give the impression that they can do it. In practice, however, they’re far better at telling you which funds have outperformed in the past than those which will do so in future. Past performance is no guide to future performance. If anything, a fund that’s been on a winning streak is more likely than others to go on a losing one.
To demonstrate the lack of persistence in outperformance, researchers at Vanguard Asset Management ranked all UK equity funds according to the excess returns they delivered for the five-year period to the end of 2009. They divided the funds into quintiles, separating out the top 20%, the next 20% and so on. They then tracked the funds’ excess performance over the next five years, through to the end of 2014.
If the funds in the top quintile displayed consistent performance, we would expect them to remain in the top 20%. But the results were relatively random. About a third of the top-quintile funds retained their position over the subsequent five-year period, but the same funds stood around a 40% chance of falling into the bottom two quintiles, or even being shut down.
There’s nothing intrinsically wrong with active management, particularly if it’s of the low-cost, low-turnover variety. It’s true as well that the markets need active managers to help set prices.
Ultimately, what active investors are paying for is the possibility of outperformance. But client in active funds have to be prepared for the overwhelming likelihood of long periods of underperformance too.
If you missed the first three articles in this series, you can catch up here:
What is the impact of fees and charges on returns?
What does cost tell us about future performance?
How do you work out the total cost of investing?