In defence of active fund management

There's no point buying a fund that simply calls itself active - it has to be genuinely active, says Merryn Somerset Webb.

Active fund or passive fund? Our answer at Moneyweek has often been that investors should buy cheap passive funds over active funds most of the time. Why? Because the average active fund costs too much and underperforms the market as a direct result. But we have recently been wondering if active management is beginning to be a little too criticised.

One of the reasons why so many supposedly active funds underperform the market so often is because they aren't actually very active. They hold portfolios that more or less track the wider market (much like passive tracker funds!), but as they charge more for their (lousy) services than tracker funds, and also endlessly overtrade, it is inevitable that they will underperform the average tracker fund. But the key word here has to be 'average'.

I've written before about the possibility of long-term active outperformance (see here and here), and a new report out from Andrew Lapthorne at Socit Gnrale backs up the idea. According to Lapthorne, most fund managers "are not active enough". Look not at all the funds that call themselves active, but at those that are "sufficiently active" and you find that they have outperformed their benchmarks after costs are taken into account.

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He quotes a 2006 study* that tried to identify genuinely active stockpicking fund managers by looking at the share of their portfolio holdings that differ from the index as a whole. The result? The higher the level of difference, the better the returns.

In the US from 1990 to 2009, the most focused stockpickers on average outperformed the index by around 2.5% a year gross and well over 1% net largely thanks to their ability to limit their downside in bear markets. The closet indexers and even the "moderately active" underperformed after costs. You can read more on this in this week's magazine out on Friday.

But the one thing to take away from this research is that there is no point in buying a fund that just calls itself active. You have to buy one that genuinely is active (ie, that has a portfolio that is very different to that that makes up the index). This isn't as easy as it used to be. In 1980, the majority of funds in the US were considered to be active under the definitions used in the 2006 paper. Today only half are. The rest are either "passive or quasi-passive".

*How Active Is Your Fund Manager? A New Measure That Predicts Performance.

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.