What active fund managers don't want you to know

Over the next few weeks, whilst the blog is on a break, I am posting some older articles that new readers may not have gotten a chance to read. This one originally posted in September 2019.

On many previous blog posts I have mentioned that passive index funds generally outperform actively managed funds over the long term, and that with each passing year, more and more active funds drop below the indexed average.

This is because it is easy to win once, but to win repeatedly over 15, 20, 30 years becomes increasingly difficult.

I realised I’d never actually shown the research to prove my claims. So today, I have some research results from international research company Morningstar.

Thankfully it’s not from Statistics NZ

Morningstar is a U.S based investment research firm that compiles and analyses fund, stock, and general market data.

The report I am referencing is the active/passive barometer report from August 2018 that measures the performance of U.S active funds against their passive peers in their respective categories,ie. Growth, value, emerging markets, bond etc.

Approximately 4,500 active and passive funds are looked at, so the results are comprehensive.

Active vs passive investments data findings

ACTIVE FUND SURVIVAL RATE

An often neglected aspect of active investing is survivorship bias. We only remember the successful funds. But it may surprise you that of the 2,414 active managed equity funds in 1998, 20 years ago, only 42% remain today.

Less than half!

That is 1,400 funds that have disappeared into smoke.

Don’t be mistaken, that is a huge failure rate. How do you know ahead of time that your actively managed funds won’t be one of them?

And that doesn’t even include the active funds that still remain, but are under performing. In other words, 58% of active funds over a period of just 20 years, have already performed worse than passive funds just by the fact they no longer exist.

ACTIVE FUND PERFORMANCE

Of the actively managed funds that have survived, 555 were winners. By winners, the report refers to funds that beat the benchmark, net of fees.

So out of a starting number of active equity funds in 1998 of 2,414, 555 performed better than their passively managed index fund equivalent.

That is a success rate of just 23% of active funds that both survived and outperformed their indexed benchmarks.

Less than one quarter of actively managed funds accomplished what they set out to do. Beat the market. That is pathetic.

A less than 25% chance to be better than ‘average’.

Passive fund returns by default then, are better than average.

And because many actively managed funds charge much higher fees than passive funds, what exactly is it they are providing for the extra cost? The 1,859 losers still collected fees for their failure.

LACK OF CONSISTENCY

The report found that of the equity funds ranked in the top 25% (quarter) for any given 5 year period, a minority of only 21% also ranked in the top quarter for the following 5 year period.

In other words, the historical best performers are rarely the best performers moving forward. That is part of the reason you need to be so careful if you are placing emphasis on past performance.

This lack of ability to consistently outperform casts serious doubts over the abilities of active fund managers to hold an edge on the market.

The data really points to active managers that outperform over 5 years are more lucky than anything else. Sure, there is about a fifth of active managers that consistently outperform the market, but four fifths that don’t is nothing to brag about. In fact, it’s downright embarrassing.

Because of this apparent lack of consistency, for periods of longer than 20 years I would expect the 23% of active funds that outperformed to index to decrease even further.

For context, between 35% to 50% of active funds tend to outperform the index in any given one year period. As you can see, 23% over 20 years is a large drop off in out performers.

Good luck picking the 20% or so of active managers, ahead of time, that will outperform the market over your investing time frame.

FEES

To add another layer to the findings, the researchers split the 555 active fund (23%) ‘winners’ into 4 different fee categories, depending on how much it costs to invest in each fund.

• Low cost

• Medium/low cost

• Medium/high cost

• High cost

Can you guess which active funds had more after cost performance winners?

Yes, the lowest cost active funds.

71% of the winning active funds were medium to low cost, and just 29% were medium to high cost.

Again, proving that highest cost funds does not mean best performance. In fact, quite the opposite.

In the majority of cases, lowest cost funds prove to be the best performing funds. What kind of twisty-turvy world is that where the less you pay the better returns you get?

Sounds like a great deal to me.

PORTFOLIO TURNOVER

The final layer of analysis looked at how frequently the active manager of the fund buys and sells stocks.

Again, they split the 555 active fund winners into 4 categories:

• Low turnover

• Medium/low turnover

• Medium/high turnover

• High turnover

Again, 71% of the winners were in funds that had medium to low turnover of stock and just 29% of winners had medium to high turnover of stock.

In other words, the less the managers did, the better the funds performed.

Final thoughts

As a financial adviser, I have seen clients invested in funds that charge fees of 1.5% or more that do little more than invest in index funds.

I have been able to recreate the same portfolio using index funds, for just 0.5% fees.

Same portfolio, but with vastly better results.

It is quite disgusting that many ‘active’ funds are basically investing in the passive indexes, yet charging active fees.

They have decided that they can’t outperform the index so don’t bother trying.

Sure, there are still active managers outperforming the market by picking individual stocks. But who are they and will they be around in 20 years? And if they are, will they outperform the index?

Clearly, most active managers are not outperforming the index enough to cover their fees.

With over 70% of investments worldwide managed by active managers, there is no danger in passive funds becoming dominant.

But looking at the statistics, why do so many people continue to pay high fees to try and beat the market? Trying to be that 20% is a hard ask when 80% of the professionals can’t. Despite the evidence, many investors continue searching for winning mutual funds and look to past performance as the main criterion for evaluating a manager’s future potential.

Active fund managers will always try to make themselves look better than they are by manipulating the statistics. Providing you with returns before fees, or by removing poor performing stocks from their portfolios and not including them in their return calculations.

If you couldn’t tell I am a big fan of index funds. You can’t control returns, but you can control how much you pay. And I have seen nothing from the data that makes it seem worthwhile to pay extra for a poorer product.

The research is pretty clear in that the markets do a good job of pricing stocks, which clearly makes it challenging for active managers to consistently outperform the index and other managers.

If you need an investment plan or recommendations , then get in touch today.

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here.