Does active fund management pay after all?

A recent report suggested more active fund managers beat their benchmark last year. Have they got better at their jobs? Sarah Moore investigates.

Studies consistently show that the average fund manager underperforms the market. So the latest fund performance report from S&P Dow Jones Indices contains a surprising statistic. Over the past year, just 8% of UK large-cap and mid-cap funds lagged behind their benchmark. European equity funds also did surprisingly well: just 33% of Europe ex-UK funds underperformed. So does this mean fund managers have suddenly become much better at their jobs?

Unsurprisingly, the answer seems to be no. One theory is that the unusually high returns are due to the funds' out-of-benchmark exposure to small-cap stocks, says Tim Edwards, senior director of index investment strategy at S&P Dow Jones Indices. Smaller stocks have fared particularly well over the past 12 months (UK small caps are up 6% this year, while large caps are down 4%).

This explanation is supported by a recent report from Neil Constable and Matt Kadnar of investment management firm GMO. They compared the proportion of US large-cap managers beating the S&P 500 against the performance of three asset classes to which the managers often allocate small portions of their portfolio: non-US stocks; small-cap stocks; and cash. The relative performance of these asset classes compared to the S&P 500 fitted closely with swings in manager performance. "The most recent bout of manager underperformance coincides with all three factors losing to theS&P 500, as do previous periods of extreme underperformance in 2011-12 and 1995-99."

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What's particularly interesting about this is that an allocation to out-of-benchmark asset classes superficially suggests that a manager is trying to do something different to the crowd. But the fact that this process leads to large swings in the number of managers outperforming implies that they are still operating in packs, increasing and decreasing their exposure to other asset classes in unison.So while investing in out-of-benchmark assets can sometimes produce better returns, it's not necessarily something that should be welcomed by investors.

It makes it harder to tell if the manager is showing stock-picking skill rather than lucky market-timing decisions. And it doesn't seem to deliver a long-term advantage (73% of UK large-cap funds lagged their benchmark over ten years). All told, it's another reminder that passive funds tend to provide a more transparent way of investing, as well as being significantly cheaper.by Sarah Moore

Sarah is MoneyWeek's investment editor. She graduated from the University of Southampton with a BA in English and History, before going on to complete a graduate diploma in law at the College of Law in Guildford. She joined MoneyWeek in 2014 and writes on funds, personal finance, pensions and property.