What Does the Evidence Say About Active Fund Management?

active-fund-management

24 Jan What Does the Evidence Say About Active Fund Management?

Active management is still seen as a desirable portfolio characteristic by many clients and their advisers. When we pay someone to manage our money, it’s reassuring to believe they have insight that we do not, and that they will seek the best returns with minimal risk.

Compare this with passive investing, which aims to simply track the market, rather than outperform. This is a cheaper option in most cases, but does that mean an active investment strategy is superior?

Efficient Market Hypothesis

A strong argument against active management is the Efficient Market Hypothesis. This suggests that the prices in the market are reflective of all known information in the public domain. Any attempt to time the market or gain an advantage is futile. This makes sense in the modern era, where sophisticated investment tools and cutting-edge data are available to everyone.

The best way to improve long-term returns, according to the theory, is to increase the amount of risk taken.
While some active fund managers do gain an advantage, this is rarely maintained over the long term. The maths simply isn’t in their favour.

Charges

A passive investment fund can cost as little as 0.10%, while some active funds cost more than 2% per year. The argument is that the active fund is expected to outperform, so is worth every penny.

From a selection of the small number of funds charging over 2% per year, the St James’s Place UK Growth fund has returned 21.51% over 5 years, while the UK All Companies Sector has returned 39.46%1.

The HSBC FTSE 250 Index has produced growth of 51.4% over the same period, and costs just 0.18%. This is a simple index tracker, with no active management involved.

This is a straightforward comparison between one of the more expensive UK equity funds and one of the cheapest. The conclusion is that more expensive is not necessarily better.

Remember, charges are predictable, but performance is not. Cost is one element of your portfolio that you can control, so it makes sense to limit this as far as possible.

Performance

Morningstar’s Active/Passive Barometer2 regularly tracks the progress of actively managed funds compared with their passive equivalents. While this is a US based study, the underlying funds invest internationally, so reflect multiple markets across the world.

The June 2019 edition found that only 23% of active funds outperformed their passive equivalents.

While this is good news for the investors holding any of the top 23% of funds, what are the chances of choosing one of those funds at outset, and holding it for long enough to see it outperforming the benchmark? A belief in active management comes with the burden of decision making, and there is every chance the fund would have been sold before reaching the 10 year point.

Volatility

While passive does not automatically mean less risky, there are a number of factors in favour of passive funds when it comes to managing volatility.

Passive funds do not rely on the judgement of a star fund manager, who may be more fallible than their track record would suggest.

Passive funds are unlikely to over-invest in a particular company, no matter how much of an opportunity it appears to be.

Passive funds are unlikely to operate leveraging (borrowing to buy more shares) or to invest in obscure assets.
However, passive funds will naturally tilt towards the larger companies in the sector, as these make up a greater proportion of the index. These means the index (and therefore the fund) is more vulnerable to the fortunes of larger companies.

The solution to this is to diversify. Investing in a single UK Equity Tracker may be simple and low cost, but it is probably outside most investors’ risk appetites.

But a diverse portfolio can be created within the passive universe. This can comprise indices across the UK, US, Europe, Asia and the rest of the world. There are indices geared more towards smaller companies, and others which track bonds or property rather than equities. There are even funds which diversify behind the scenes, and aim to track multiple indices proportionately.

Regardless of your requirements and risk tolerance, there is likely to be a passive investment solution that can meet your needs at least as well as an active portfolio.

Please do not hesitate to contact a member of the team to find out more.

1 All performance and charge data obtained from FE Analytics on 22/01/2020
2 https://www.morningstar.com/lp/active-passive-barometer