Successful money managers are few and far between, as Osam's Patrick O'Shaughnessy says in a recent research paper. But finding a good one will give you better returns, despite the higher fees, than you'll get from any passive tracker fund or exchange-traded fund(ETF).
The problem is, this isn't easy. Between 1991 and 2009, according to Morningstar data, only 30% of actively managed funds beat the S&P 500 after fees in any given ten-year period. And even that doesn't give a true picture, because all the funds which failed in those periods are excluded.
The reason for this dismal performance is simple high fees. According to the Investment Company Institute's 2012 Factbook, the average expense ratio of an actively managed fund is 0.93%, "more than six times as expensive as the average index fund fee of 0.14%". The world's largest ETF tracking the S&P 500 (NYSE: SPY) has a ratio of 0.09%.
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Measured like this, the case for passive tracker funds and exchanged-traded funds seems compelling. They cost far less and they deliver good, steady returns. They also don't chase the latest fad, nor do they face pressure to outperform peers in the short term.
The problem is that passive funds follow indices that pick stocks based on market capitalisation (the number of shares in issue multiplied by the share price). And the long-term evidence, says O'Shaughnessy, makes it very clear that this is "a losing strategy".
He compares the performance of "sector leaders" the largest US stocks in ten economic sectors measured by market cap and his "sector bargains" the cheapest stocks relative to sales, earnings, cash flows and dividends.
Back testing since 1963, he finds that the sector leaders that would be favoured by most passive funds returned 8.54% annualised, 1.3% lower than the S&P 500 index itself. His sector bargains managed 14.6% after deducting a 0.14% annual fee for the leaders and a 0.93% (active-style) fee for the bargains.
Why leaders let you down
If you buy market leaders by size you pay a premium because everyone else is doing the same thing. "History shows us that the curious inversion in investing is that the less you pay, the more you get."
So a leader like Monsanto (NYSE: MON) costs $24 for every $1 of earnings, but a dollar of sales from WellPoint (NYSE: WLP) costs just $0.3. So there is clearly a place for active stock selection following value-investing principles.
To show how far adrift sized-based stock-picking can go, O'Shaughnessy compares annualised returns for US stocks between 1963 and 2012. He allocates a 0.14% fee to the S&P 500 index-following strategy and 0.93% for the others. The results are striking.
Pursuing an equal weighting approach (putting an equal amount into the top stocks, not an amount driven by their relative size) returns 9.26% after fees and a sales weighting approach 9.71% (ranking stocks by sales). The passive index approach returns just 8.96%.
How to make this work for you
A recent Osam study of active mutual funds shows "the more unique a fund's holdings, the better the fund's returns before and after costs". The least active funds, which tend to pick the highest number of stocks also chosen for the index, underperform the market by around "0.43% per year after fees". Paying active management prices for passive performance doesn't pay.
However, the most active managers outperform by 2.4% annually before fees and 1.13% afterwards. So active funds have their place, but you must find ones that run portfolios that are different to the broad index. How?
As a DIY investor you can track down the fund fact sheet and take a look at the strategy plus the top ten holdings. If they are popular stocks in the main index the fund may be a closet tracker so avoid it. Next, using say Trustnet.com, overlay the index against a fund's five-year performance. If the two lines follow each other, watch out.
As for last year's best-performing sector, it was small caps, stocks which are often outside a main index. But that bull run may be over.
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.
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