Don’t expect the shift from active to passive fund management to ever reverse

FTSE indexes © Luke MacGregor/Bloomberg via Getty Images

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The flood from active funds (those run by managers who actively buy and sell assets with the goal of beating the market) to passive funds (those run by managers who simply track an underlying index in order to match it) just keeps going.

Data from Morningstar, cited in the FT this morning, suggests that index tracking funds now account for more than a third of the market for US funds.

Europe is running a distant second – at around 18% of the market – but both have seen their share continue to grow strongly year-on-year.

Will the pendulum ever swing back to active fund managers?

Honestly? I suspect not – at least, not in their current format.

The idea of a “comeback” for active fund management assumes a non-existent golden age

The spectacular downfall of Neil Woodford, one of Britain’s best-known fund managers, won’t help. Nor will concerns around liquidity that have also caused problems at other, less high-profile funds, such as some of those run by H2O Asset Management and Swiss group GAM.

But, fundamentally, this is just a continuation of a process that has been going on for many years now. Active funds cost more and, on average, they return less than the market. Not only that, but you also run the risk of picking a real dud, and earning a lot less than the market.

Passive funds, on the other hand, are cheap, and you know that you’re going to get the return on the market, or thereabouts. Given the odds, why would you go with anything else?

The obvious question – and one that active fund managers keep trying to reassure themselves about – is: “what could turn this around?”

Is passive investing some sort of bubble? When will active investing have its day in the sun again?

If this were a cyclical business, then the headlines over Woodford and the rush into passive might indicate some sort of contrarian turning point.

And there may be fragment of truth to this. Another feature of this most recent bull run in markets is that “value” has massively underperformed “growth”. Index tracking in its most basic form is closer to being a growth strategy than to being a value one – you buy more of what’s going up and less of what’s going down.

So when the environment changes (which history indicates will happen at some point), and value starts to outperform again, investors in plain old index funds will start to struggle.

But will that send them flooding back to active fund management? I very much doubt it. The cohort of “celebrity” (in the financial sense) fund managers might shift in composition, but the reality is that most active fund managers will continue to underperform. It’ll just be a different group that bucks the trend.

And this is the big problem with the idea of active funds making a comeback. Because active has never consistently outperformed. There is no “comeback” to be had, because there’s nothing to come back to.

This isn’t a downturn in active performance – this is simply about index funds being widely available and investors waking up to the better overall returns they can get from them. This is a technological shift, not a cyclical mood swing – it’s like arguing that the fax machine is due a comeback (for real, obviously, not an ironic hipster comeback).

What could save active funds?

What has to happen to reverse the flood from active to passive funds? It’s simple – active funds have to prove that they have at least a fighting chance of doing the job they claim to do. And realistically, the only way they can do that is by slashing their cost of investing.

As yet another study has just shown, the issue is not that active managers can’t beat the market (at least sometimes), it’s that they charge too much for doing so.

“Investor rights” group Better Finance looked at nearly 2,000 equity funds across France, Belgium and Luxembourg. They found that the more expensive the fund, the worse the performance (after fees). In other words, if you pay more for a fund, you’ll get poorer returns.

On the one hand, this is entirely logical – the higher the fee, the better the performance has to be in order to recoup it plus deliver market-beating returns on top. Yet, on the other hand, it goes against our instinctive belief that “what you pay is what you get”.

The good news for investors is that the message is getting through. That’s not such good news for the active fund management industry, although the question is how much of that is already priced into their shares (that’s a topic for another day).

In the meantime, if you’re looking for active investors who might be able to beat the market, then I’d suggest ignoring the open-ended (unit trust, Oeics) sector altogether.

Investment trusts (funds that are listed on the stockmarket) are not perfect by any means. But the structure of the funds means there is less tension between the goal of the fund manager and the needs of the investor.

For example, it’s harder for an investment trust to become a pure asset-gathering operation, because issuing new shares involves actively deciding to do so and getting the agreement of a board who are meant to stand up for existing shareholders’ best interests.

Also, data from various researchers consistently suggests that investment trusts in general beat their open-ended peers, and even have a decent chance of beating the underlying market.

You still have to watch your cost of investing. And not all investment trusts perform well (just look at Neil Woodford’s Patient Capital Trust, for example). But if you have decided to go active, then this is the way to go.

MoneyWeek has put together a small model portfolio of investment trusts – you can read more about it here.

Oh, and if you want to hear from one of Britain’s top investment trust managers – James Anderson of Scottish Mortgage Trust – book your ticket for the MoneyWeek Wealth Summit on 22 November now.