We live in an era of industry disruption, and the investment business is no exception. Not so long ago, most private investors put their money to work in a fund that was actively managed, with the aim of delivering a better return than the market. But the last few decades have seen the remorseless rise of “tracker funds”, which simply aim to copy the performance of an underlying market by mechanically investing in the businesses within an index.
This rise to dominance has been led by exchange-traded funds (ETFs). In the US, for example, ETFs now outsell traditional mutual funds on a month-to-month basis. At the end of 2019, inflows into these passive, index-tracking funds had totalled $570.5bn, up 10.6% according to London-based consultancy ETFGI. ETFGI also reported that “the ETF industry globally is $2.5 trillion bigger than the hedge fund industry”. An even more astonishing figure to note is that in the US, just ten of these ETFs now account for a staggering 28% of total US assets under the control of all fund managers.
Cheap and cheerful
It’s not hard to see why passive index-tracking funds are popular. They are much cheaper to run than more traditional structures, and in the US a price war has already erupted, with issuers producing ETFs with no management fee at all. But cost isn’t the only factor. Investors have also grown wary of the claims made by many active fund managers. If active managers regularly outperform the market, then their extra fees might be worth it, but the data suggests otherwise.
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Researchers at S&P Dow Jones conduct a regular survey called SPIVA which looks at returns from active managers over varying time spans, then compares them to “benchmark” index numbers. The 2019 SPIVA survey for Europe revealed that over the one-year period, 81.5% of UK active equity funds underperformed the S&P UK benchmark. Over the longer run, things aren’t much better – over a ten-year period, 74% underperformed. Of course, there are exceptions and some active fund managers have outperformed indices in the long term, sometimes by considerable margins.
In the recent turbulence, the tide has, to a degree, turned in the favour of active fund managers. Recent figures put out by another research firm, FactSet, suggest that many of the big ETF firms have seen assets under management decline during the Covid-19 crisis, with huge amounts of money being pulled out of bond fund trackers in particular. By contrast, actively-managed funds saw material inflows. When faced with extreme market instability, many investors have sought shelter with active managers.
When active management shines
You shouldn’t see the choice between passive and active as a binary option. It depends hugely on where you are investing your money. It’s extremely hard for active managers in some areas – such as US large-cap equities, for instance – to eke out a consistent competitive advantage. The US market is so huge, and so widely researched and well understood, that it’s hard to understand how an active manager can gain an edge, unless they are willing to take a lot more risk.
But not every market or asset class is quite so well developed, liquid and efficient as the US market. Many consist of much smaller, harder to understand companies, which can mean real opportunities for a smart active manager. Professor Andrew Clare of Cass Business School examined fund managers in European markets and found that the advantage for tightly focused stock pickers was most pronounced for European (including the UK) mid- and small-cap funds, and global emerging market funds. In these circumstances – “smaller” (compared to the US) markets and more specialised asset classes which aren’t as easy to track – maybe active managers can come into their own.
If that is the case, what should investors look for in active fund managers? You are almost certainly not looking for a “closet tracker” – i.e. a fund manager whose holdings look mostly like the index, but with small variations. Why pay extra fees for something that’s basically just a passive fund? Instead, a focused active manager might have a more concentrated portfolio (which also means it could be riskier), owning fewer stocks but ones which are deeply researched. Remember, computers still can’t visit businesses to understand their competitive advantage.
A great track record – over multiple time frames of say one, three, five and 10 years – is of course relevant, but don’t be too carried away about past performance. What matters more is a clear investment strategy, well-articulated, and executed actively. There’s also some (limited) evidence that a manager with many years of experience – maybe stretching into the decades – in running top-quartile funds provides some edge, especially in managing downside risk. Last but by no means least, remember not to overpay for all this active management. Active outperformance is valuable – but not if all of that advantage is eaten away in fees.
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