Can fund managers deliver value?

Top fund managers do add value for investors, says a recent study. So should we forego trackers and hunt down the best fund managers? Tim Bennett reports.

"Rejoice, active fund managers!" says Adam Lewis in Fund Strategy. According to the latest research on fund management performance, the best fund managers are worth paying for they do have the ability to add value for investors. The bad news is that tapping that extra value as a retail investor is fraught with difficulty.

Researchers at specialist fund evaluation firm Inalytics set themselves two challenges. The first was to define what constitutes skill (or alpha') in fund management. The second was to work out what extra return an investor could expect to earn from following the best managers.

After analysing 760 global equity portfolios, Inalytics concluded that the most skilful fund managers share three traits: they get more investment decisions right than wrong, they run their winners, and they know when to cut their losses.

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To be blunt, this is all incredibly obvious stuff. Studies of investing psychology have proved many times that we all like to bank early profits as evidence of our skill,and none of us likes to admit to making a mistake. So we sell good stocks too soon and run duff investments long after we should have sold them. Probably the most interesting aspect of the Inalytics study is just how crucial running winners and selling losers is and the sheer difficulty that even the experts' have in doing this.

So how much extra value do the best managers add? The answer is 242 basis points 2.42% per year above the average for the top quartile (the top 25% of managers). So should we abandon trackers and instead try to hunt down the best fund managers?

In theory, yes but in practice it's tricky. How do you know who will stay hot? Even fund managers with the best track records get it wrong, as anyone who followed superstar manager Anthony Bolton into China knows. And getting it wrong can be expensive. The bottom two quartiles containing the least-skilful managers returned 101 and 238 basis points per year below the average. In a tough market, that would translate into a truly awful absolute return for the worst funds.

That's why the main criteria to consider when picking a fund still has to be the one thing you have any sort of control over the costs. If you can shave, say, 1% a year off the cost of investing you'll boost the end value of a fund, regardless of its performance. The best way to do that? Buy low-cost investment trusts and cheap passive' investment products, such as exchange-traded funds (ETFs).

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.