Active funds failing to beat passives amid technology boom - how should you invest?

Active fund managers may sell themselves on being able to outperform the markets over the long term but they are continuing to struggle against passive alternatives amid a technology stock boom.

Research has revealed that only around a third of active fund managers have beaten the average passive fund performance in their sector during the second half of 2024.

It comes as investors will have been seeking returns to combat high inflation and borrowing costs, suggesting many could be wasting money on fund manager fees when they could earn the same or better returns with a passive fund.

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The findings come from AJ Bell’s latest Manager versus Machine report, which compares active fund performance with passive alternatives.

AJ Bell’s latest data for the second half of 2024 shows only 33% of active equity funds have beaten the average passive fund in their sector in 2024 – down from 35% at the halfway point of 2024.

Meanwhile, just 31% have outperformed over 10 years.

That means investors could be better off putting money in a passive fund for most sectors rather than choosing an active fund. This trend is reflected by more than £100 billion coming out of active funds over the past three years, with competition from trackers, ETFs, bitcoin, mortgages and cash.

However, performance can vary among index funds as well so investors still need to do their research to find the best fund.

“Make no mistake, passive funds are eating the lunch of active managers, and the continued strong performance of index trackers will do nothing to staunch this trend," says Laith Khalaf, head of investment analysis at AJ Bell.

"Whether you look at the short term or zoom out and take a wider perspective, the picture remains dismal for active managers, and it’s the influential Global and North America sectors where a lot of the damage is being done."

Why are active fund managers struggling?

Much of the underperformance of active funds is attributed to the continuing popularity of technology stocks, particularly the rise of the Magnificent 7.

Global technology brands such as Amazon and Nvidia are dominating global and US markets, making it harder for active funds to compete, especially if they are not focused on this sector or are in different regions.

Nvidia was responsible for 25% of the returns of the US benchmark in the first half of 2024.

"Active managers can of course invest in these companies, and many do, but few will take on as much exposure as an index tracker," adds Khalaf.

"To match a passive fund, an active US equity manager would now have to hold a third of their portfolio in Magnificent Seven stocks, including three individual stock positions above 6% in each of Apple, Microsoft, and Nvidia.

"Doing so would then guarantee underperformance on that portion of the portfolio, once active fees have been deducted, and place a huge burden on the remainder of the fund to beat the market, which is of course the goal of active management. When it comes to Magnificent Seven exposure, active managers are damned if they do, and damned if they don’t."

Some of the outflows from active funds has also been blamed on chancellor Rachel Reeves and her Autumn Budget, with many investors selling assets ahead of expected capital gains tax hikes.

“Rachel Reeves can also take a bow for prompting a flurry of outflows from investment funds," adds Khalaf.

"In the lead up to the Budget, rumours of a capital gains tax raid were plentiful, and some appeared to have been sourced from within the Treasury. In September and October, over £9 billion was withdrawn from investment funds by retail investors, as they scrambled to encash profits ahead of a possible capital gains tax raid."

The best and worst performing regions for active funds

The best region for active funds this year has been Japan, according to AJ Bell.

Its analysis shows 46% of active funds outperformed their passive alternative, just ahead of the 41% in the Asia Pacific ex Japan sector.

The worst was the global sector, where just 18% of active funds outperformed.

Active fund performance is better on a five-year basis in some regions such as Global Emerging Markets, where 52% of active funds outperformed.

Perils of passive investing

Passives may have done better in most sectors, but it is important to choose the right investment fund.

Analysis from AJ Bell’s earlier this year found one fund tracking the FTSE 100 has turned £10,000 into £17,940 over 10 years, while another has offered up just £16,400.

“There are two main factors which explain the dispersion of passive fund performance,” says Khalaf.

“One is the index selected to be followed. This is by no means uniform within each equity sector, for instance in the Global sector, where over 10 years the S&P Global 100 index has trounced the MSCI World Index to the tune of over 80 percentage points.

“The other factor is charges. For two funds tracking the same index, the difference in return can largely be laid at the door of charges.”