Manager vs Machine - are active funds delivering value?

•    85% of UK active funds have beaten the average tracker in the last 10 years
•    Only a third of active Global funds and a quarter of US active funds have outperformed a passive alternative
•    But an underperforming US fund was still a better place to be invested than an outperforming UK fund
•    The worst performing UK tracker fund has underperformed the best performing tracker by 24%
•    Five of the top ten UK performers are ethical funds 
•    UK active managers are flattered by midcap performance, and expensive tracker funds

Source: AJ Bell, FE Total Return GBP 14/05/2011 to 14/05/2021

Laith Khalaf, financial analyst at AJ Bell:

“Returns in the last ten years have been all about where you put your money, rather than who you invested with. The US stock market has been the place to be, and that’s reflected in the strong absolute performance of active funds investing across the pond, and global active funds too, because the US now makes up such a large part of the investable international universe. It’s simply been better to be invested in a poorly performing US or global fund, than a UK highflyer.

“However active managers as a whole have not thrived in the US and Global sectors, and only a small proportion have beaten a typical index tracker. In contrast, the UK has been a bright spot for active management, with more than eight in ten active funds outperforming the average tracker, despite absolute returns looking shabby compared to global and US peers.  Our analysis suggests that investors with a budget for active management would therefore be better off allocating this to the UK portion of their portfolio, rather than the Global and US sectors.

“While they are in the minority, in the global sector there were still a substantial number of funds which posted strong outperformance of their passive peers, including offerings from well-known names like Baillie Gifford, Fundsmith and Lindsell Train. However, these are the exception rather than the rule, and so investors need to be very discerning if they are allocating money to global active managers. Of course, it pays to be discriminating wherever you’re allocating money, but UK funds have shown a much greater tendency to outperform their passive peers over the long term, so your chances of getting value from active management are improved when you go fishing in this pool.”

UK managers – flattered by midcaps

“Undoubtedly there are skilful active managers plying their trade in the UK, but there are also structural reasons why the UK market is a fertile hunting ground for active management. The standout performers of the last ten years in the UK have been mid cap and small cap stocks. Active managers tend to be overweight these areas, while index trackers have most of their portfolio invested in the FTSE 100, because they just invest according to market cap. 

“The FTSE Small Cap index has returned 187% over the last ten years, and the FTSE 250 has returned 143%, compared to 74% from the FTSE 100. That performance differential gives quite some tailwind to active managers, even if they are only slightly overweight mid and small caps. Indeed, this helps to explain why there are so many ethical funds at the top of the performance table in the UK, because their focus on ESG credentials naturally leads them away from the big blue chips to more modestly sized companies. Multicap funds also feature heavily at the top of the performance table for the same reason.”

Source: AJ Bell, FE Total Return GBP 14/05/2011 to 14/05/2021

“The strong outperformance of UK mid and small caps is in stark contrast to the US where in recent years, exceptional performance has been derived from megacap stocks like Apple, Alphabet and Amazon. These stocks will be in the top holdings of passive funds in both US and Global sectors, lifting the bar that much higher for active managers operating in these areas, because these companies have delivered such high returns. In the US, small and midcaps actually underperformed the big beasts of the S&P 500, as the table below highlights. The high returns of the US mega cap stocks, combined with a well-analysed, efficient market, means that the average tracker fund actually nestles just inside the top quartile of active US funds. Or in other words, it’s possible for a US fund to have just made it into the top quartile of its active peers, and still have underperformed the average passive fund.”

Source: AJ Bell, FE Total Return GBP 14/05/2011 to 14/05/2021

Tracker slackers

“In the UK there is also a much wider dispersion of returns amongst passive funds compared to the US, with some funds posting performance significantly below their benchmark index. This lowers the threshold UK active managers need to beat to outperform the average tracker. In part, this again comes down to the highly divergent performance of small and mid-caps compared to large caps, because some of the trackers available to UK investors simply follow the FTSE 100. But even looking at funds tracking the broader FTSE All Share, the best performing passive fund returned 84% over ten years, and the worst performer returned 66%. This comes down to that silent destroyer of tracker performance - charges. 

“Many UK tracker funds are now keenly priced to support investor demand, but there are still a few ‘tracker slackers’ kicking around - passive funds which charge fees more commensurate with an active approach. If your gross returns are simply the index, high charges on a tracker fund are going to lead to substantial underperformance over the long term. It just goes to show, even tracker funds aren’t created equal, so if investing passively, you still need to exercise some discretion when it comes to fund selection.”

Source: AJ Bell, FE Total Return GBP 14/05/2011 to 14/05/2021

Why trackers not indices?

Active fund performance is usually measured against an index, but the real world alternative for investors is actually a passive fund, which tracks the index, but importantly also incurs the costs that are part and parcel of investing. Index performance, by contrast, is a purely theoretical construct that incurs no costs, and so can’t actually be achieved by investors, without taking an active approach. By comparing active funds to passive performance therefore, rather than the index, we can build a better picture of whether in practice investors should be adopting an active strategy with their investments. 

Analysis notes and exclusions

Our analysis looked at 280 active funds with a ten-year track record in the three most popular Investment Association sectors with retail investors- Global, UK All Companies, and North America, which together account for £400 billion of investors’ assets. We compared returns of these active funds to returns from the average passive fund in the same IA sector. 

We excluded from the analysis funds investing specifically in mid and small caps, specialist funds focused on one particular area of the market, and ETFs. We also excluded funds without a ten-year performance record, so there will be an element of survivorship bias in the data, and while in theory this should apply to passive as well as active components, it is more likely to have an effect on the latter.