Last Monday (21/3/2016) there was a front page story in the FTfm supplement which was headlined “86% of active equity funds underperform“. The article said that a study by S&P Dow Jones Indices showed that “almost every actively managed fund in Europe investing in global, emerging and US markets has failed to beat its benchmark over the past decade….”. The article went on to question the value added by stockpicking fund managers at some length
Now it immediately struck me that the authors of this study might be keen to promote the use of indices and index tracking funds so they might not be totally unbiased. But the real elephant in the room that the article did not even mention was the question of how many passive funds underperform the market. I was intending to write to the FT and publish a blog article on this subject but never got around to it. However, it did not pass unnoticed by another reader and the FT have published a letter from him today.
Mr St. John Mound pointed out in the letter that logically since passive funds are designed to match the benchmark as closely as possible, but also charge fees, the percentage beating their benchmark after fees will be even lower than that for active funds. To put it another way, it is likely that 100% of passive funds will underperform their benchmark. That is ignoring the fact that few passive funds perfectly match their benchmark and that indices might overstate the likely performance you will achieve simply because of companies dropping out of an index and being replaced (the “survivor bias” problem).
What needs to be examined is the relative performance of active and passive funds, and the relative fees they charge. Active funds may charge more on average than passive funds, although there are some low cost active funds just as there low cost passive funds.
Perhaps the headline in the FT should have read something like “14% of active equity fund managers overcome the drag of high fund management fees”. Whether that is by skill or luck is another debate worth having though. But the original article was certainly sloppy journalism no doubt prompted by an organisation keen to promote the merits of index tracking.
Before anyone jumps to conclusions about whether this writer favours active or passive funds, let me just say that I consider this more a question of what the investor wants and whether they have the judgement to select good active funds or not. Index tracking funds are a “no-brainer” kind of choice to some extent which might relieve the investor of giving the choice much thought, although even here unless you are tracking a global index rather than some more specific index there can still be dangers.
One type of fund manager to avoid is of course the “closet index trackers” who charge high fees while achieving only index matching performance. These are more common than you may think and they have been getting some negative publicity of late.
Even better perhaps might be to avoid paying management fees altogether and pick your own investments because management fees can seriously erode your long term returns. There is a chapter in Terry Smith’s latest book (entitled “Celebrating five years of investing in decades of success”) which spells it out. Part 5 of the book explains why minimising fund management fees and other intermediary costs are so important because they can easily consume all the income that is being generated from the underlying businesses. It’s well worth a read even if Mr Smith might have a certain stance as he runs an active fund (Fundsmith).
In the investment game, even just a little thought about these matters can help you sort the wheat from the chaff.
Roger Lawson
I think equating “passive” with “index” and vice versa as most commentators do is misleading. Index trackers are not in general all that passive because the index constituents and weights keep changing (often predictably by people front-running the changes), although the amount of change varies with the index. Whenever a fund is churned it incurs costs – although again it varies, e.g. large companies have smaller spreads than smaller ones. From that point of view Fundsmith is not an active fund, it trades holdings very rarely. In general I would say that the evidence supports passivity in that sense, i.e. a fund manager who sells one company to buy another usually doesn’t add enough value to cover the cost of the trade (although funds don’t publish enough information to tell you for sure). However, a fund manager who mostly does nothing has a high risk of getting fired – Terry Smith is very much an exception.
A good point. Of course Terry Smith has an advantage of being difficult to fire.
Roger Lawson