In defence of active fund management

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.