The case for active funds, and how to spot a good one

Few people today doubt that the average investment manager consistently underperforms their market. Countless studies have shown this, wherever you look in the world. Some 65% of UK equity funds lagged behind the FTSE All-Share index over the past ten years, according to fund data firm Lipper. More than 80% of US large-cap funds lagged the S&P 500 over ten years, says index compiler S&P Dow Jones Indices.

Even in niches where markets are supposedly less efficient and managers claim they can easily add value, the hard numbers are damning 89% of US-based emerging-markets funds underperformed theS&P/IFCI Composite over ten years.

That means that unless you are especially skilled, or especially lucky in picking funds that can beat those odds, you will do better by investing in low-cost passive funds that aim to track their indices as closely as possible. By doing so, you give up the chance of outperforming the market, but you also reduce the greater risk of underperforming. This message is increasingly resonating with investors hence passives now account for around 25% of assets in equity funds in the UK and almost 30% in America.

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The new case for active funds

Unsurprisingly, active managers are rattled by this shift to passive investment, which shows no signs of losing momentum. And since the statistics make it difficult to claim that active management is a route to higher returns, a new argument in favour of active management is increasingly put forward. In essence, this claims that while active managers may not beat the market overall, they still serve a vital purpose.

By competing to identify and invest in better companies, they ensure that good stocks are recognised and poor ones punished thereby enabling stockmarkets to work efficiently. This ensures capital is allocated to where it will be employed most effectively, which benefits the wider economy and boosts economic growth.

Passive funds don't do this instead, they blindly buy stocks according to their weight in the index. So in a world full of passive investors, markets would not fulfil their role, argue active managers. Money would flow to shares in large companies that were in long-term decline, while smaller businesses with huge potential would be unable to attract investment.

Does this argument stack up? That's hard to prove one way or another, but investors should remain cynical. It's fairly obvious that a market entirely dominated by passive investors would create a lot of problems. But that's a long way from today's world, where the substantial majority of money is still invested in funds that are, theoretically, actively run. And there's a fair amount of evidence to suggest that these managers are not doing the crucial job they claim.

The persistence of anomalies such as the momentum effect (stocks that have been performing well tend to continue rising) and the value effect (stocks that are cheap tend to outperform) are not the hallmarks of an efficient market.

The problem of closet indexing funds that claim to be active managed, but in reality stick close to their benchmark in order to minimise the risk of underperforming is widespread. And studies such as the Kay Review have concluded that UK equity markets largely fail to achieve their supposed objectives of allocating capital and promoting good governance, in part due to a short-term approach to investment among fund managers.

Cut charges to survive

Yet perhaps the biggest reason to condemn active management is not that it does an imperfect job it's that the industry charges excessive fees for those failures. Asset managers worldwide are earning very healthy profits. Since their fees come out of the funds they manage, higher profits equal higher costs for investors. If higher fees equalled higher returns, that might be justifiable, but studies show that funds with lower fees tend to perform better.

So if active managers want to survive the passive onslaught, they'd be better off bringing down charges, rather than pleading that the world owes them a living. Until that happens, passive investors should ignore the implication that they are undermining capitalism. Instead, they should focus on getting the best deal by buying a cheap tracker fund, instead of paying over the odds forsub-standard active management.

How can you spot good active funds?

MoneyWeek is a firm advocate of index funds and exchange-traded funds (ETFs), but we also believe that successful active investing is possible. Indeed, some studies suggest that even the average active manager has enough stock-picking skill to beat the market before costs it's just the gains are swallowed up by expenses. The difficulty is identifying those managers who are likely to beat the market after costs over the long term.

Research suggests that there is no magic formula, whichis why passive funds should be the default choice for most investors. But we believe that many successful managers have certain traits in common. So we suggest looking for a clear, consistent and disciplined strategy, a relatively concentrated portfolio (showing the manager has conviction in their ideas), a willingness to deviate significantly from the benchmark (you can't outperform if you hold the same assets as everybody else) and low portfolio turnover (excess trading drives up costs).