Most active fund managers are failing to beat passive alternatives – how should you invest?

Active vs passive is on ongoing debate, and while active fund managers may be making a comeback, research from investment firm AJ Bells shows only 36% actually outperformed.

Investors have had to seek a decent return from the stock market amid uncertainty around interest rates and inflation for much of the year, but even the professionals seem to have struggled.

Research shows that active managers are struggling to outperform their passive alternatives, meaning investors could be paying high charges for poor performing funds.

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Investment platform AJ Bell’s latest Manager versus Machine report, found just 36% of active managers beat the average passive alternative in 2023 across seven key equity sectors.

The report, which compares the performance of active funds against passive alternatives such as a tracker or exchange traded, found this figure is at least up from 27% in 2022.

AJ Bell says it highlights why £9 billion has been withdrawn from active open-ended funds by retail investors over the past five years, while at the same time a net £75 billion has flowed into passive strategies.

Laith Khalaf, head of investment analysis at AJ Bell, says it is “another year of lacklustre performance” for active management” that may deter investors.

The difference between active and passive funds

Picking the best stocks can be time consuming and requires a lot of research.

A fund can help build a diversified portfolio of different stocks, backing companies across a range of sectors and regions.

Using an active fund means trusting a fund manager to choose the best companies to invest in and to monitor the portfolio to ensure it is setup to perform well for the current and future market environments.

Ideally, an active fund manager will beat their market or benchmark over a long period, providing value for the fees you pay.

In contrast, you could use a tracker or ETF to just benefit from the growth of a particular market or index. 

These passive funds tend to be cheaper than active portfolios as there is no extra skill or human to pay for. Your charges just go towards the machine that has built the portfolio to reflect an index and you will benefit if the market performs well, while also losing out if the market dips.

Active managers versus the machines

It is important to invest for the long term so judging an active fund over one year can be a bit unfair.

However, the AJ Bell research shows that over 10 years, just 32% of active equity funds have outperformed the passive machines, compared with 56% in 2021.

Only a quarter of active global funds managed to outperform the passive alternatives in 2023, AJ Bell said, and this falls to 22% over 10 years.

UK funds have actually fared better this year, with 44% outperforming their passive alternatives, that is up from 13% in 2022.

However, just 36% have outperformed over 10 years, compared with 85% in the 10 years to the end of 2021.

Investors do appear to be getting value from active emerging market funds though, with 57% outperforming this year and 47% doing better than the machines over 10 years. 

AJ Bell highlights that outperforming active funds tend to have lower charges.

For example, the top performing global funds typically had ongoing charges of 0.86% compared with 0.99% among the underperformers.

“While all active fund investors expect outperformance, it’s not statistically possible for all managers to outperform. Investors therefore need to pick their battles wisely,” adds Khalaf.

“This means acknowledging that some markets have proved more difficult to beat than others, and selecting active fund managers in whom they have a high degree of conviction. 

"A long and successful track record suggests outperformance has been achieved by skill and not just luck, but it’s still no guarantee for the future, so any active portfolio should include several managers for diversification.”

He adds that investors can blend both active and passive strategies to get a bit of the best of both worlds.

Not all passive funds will have the same performance either due to how they are setup to track an index and their charges.

Over 10 years the difference between the best and worst performing global tracker fund is 76%, according to AJ Bell.

“This is particularly relevant when you consider there are some areas of the market which are not well served by passive vehicles or which generally favour an active approach, such as producing income, preserving capital or investing in small caps,” Khalaf adds.

“Investors in passive funds shouldn’t be too complacent, either. They still need to make some active decisions in terms of their index selection and picking a competitively priced fund. 

"The performance gulf between the most expensive and cheapest passive strategies is quite startling, and this is a gap that investors can bridge quite easily by simply switching funds.”