Active managers can pick the winners – but they keep the winnings to themselves

It's not that active fund managers can't beat the markets, says Piper Terrett. They just don't want to share the profits.

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Any gain from beating the market is swallowed up by fees

Whether talented fund managers can outperform the market is a perennial argument in finance for obvious reasons, asSteve Johnson notes in the FT. "Belief in this concept helps sustain the comfortable lifestyles of a veritable army of well-paid managers, consultants, fund selectors and advisers."

Yet a vast battery of statistics suggests that active management is, on average, a waste of effort: less than 20% of actively managed US equity funds beat their benchmarks last year, says Lawrence Strauss in Barron's. So it's no wonder that investors are increasing turning to low-cost passive investments, such as index trackers and exchange-traded funds (ETFs). Indeed, 2014 marked the ninth consecutive year investors have switched money from active funds into trackers and ETFs.

But is this entirely fair to active managers? Research from Joe Mezrich and Yasushi Ishikawa at Japanese bank Nomura suggests it may not be, says Johnson. In a new report, Your Fund Managers Really Can Pick Stocks, Mezrich and Ishikawa use information on funds' holdings that US funds supply to the Securities and Exchange Commission to analyse whether funds are more likely to hold stocks that outperform or underperform the market.

They found what appears to be a strong positive relationship: between 2004 and 2014 the 10% of stocks that the funds were most underweight in performed the worst, lagging the Russell 1,000 benchmark by 6.3 percentage points per year. The greater the weight that funds have in each group of stocks, the better the stocks perform (except for the top 10% the most overweight which were only the third-best performing group).

In other words, fund managers seem to be successfully picking the stocks that do better. As a result, the funds' holdings outperformed the Russell 1,000 by an average of 2.1 percentage points over the study period.

But there's a snag, continues Johnson. "The average investor does not see the fruits of managers' stockpicking labours." That's because funds' costs swamp the outperformance of their holdings. The average US equity fund has all-in costs including fees and transaction costs of 2.27% per year, according to Jack Bogle, founder of Vanguard, the world's largest passive fund manager. Once you take account of that, the average fund will still be underperforming the market, even if the manager's stockpicks outperform before allowing for costs.

This means that low-cost passive investing is still likely to be a better strategy for investors than trying to find market-beating managers. However, it's important to bear in mind that, just like active funds, not all low-cost index funds and ETFs are alike. Some will be better at tracking their index than others, so it's important to take this into account when selecting funds (see below for more on this).

How good is your tracker?

Comparing passive funds is harder in some ways than comparing active funds, says Kate Beioley in Investors Chronicle. The best active fund is the one that beats its benchmark (although, of course, studies show that strong past performance is not a good guide to whether a fund will beat the market in future).

But passive funds, such as ETFs, operate differently: they aim to replicate closely the performance of a certain benchmark, such as the FTSE 100. So the best fund is the one that matches the index most closely, neither underperforming not outperforming by too great a margin.

FE Trustnet's system which you can find at trustnet.com/passive-funds awards ETFs a rating between one and five "crowns", depending on their effectiveness in tracking a particular index ("tracking difference"), as well as the volatilityof that difference ("tracking error") and liquidity (the size of the gap between the price at which you can buy and the price at which you can sell at any given time). It only tracks funds with a three-year history, and that follow indices most of interest to UK investors, and so compares around 229 ETFs following UK, American and Japanese equities.

So far 55 of the 229 ETFs tracked by the service have been awarded five crowns, says Investment Week, while 32 funds have only one. Providers iShares and Vanguard come out top, with 13 and seven funds respectively gaining five crowns.

Examples of five-crown FTSE 100 trackers include those from Lyxor (LSE: L100) and iShares (LSE: CUKX), which have tracking difference of 1.18% and 1.73% respectively over the past three years. At the other end of the scale, some one-crown FTSE 100 trackers have tracking difference of 6% or more. The difference is partly due to the excessive fees that some of these funds charge: at 1% per year, they are over ten times as expensive as the iShares fund, despite having exactly the same objective.

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