As regular readers of the Biograph blog know, most active fund managers underperform for most of the time. The evidence is overwhelming. A common response to that assertion from those who advocate active management is that active funds do prove their worth in periods of market volatility and in bear markets.
That’s a very comforting thought for investors. After all, no one likes to see the value of their investments plummet when, as inevitably happens from time to time, markets fall sharply. If you can reduce those losses by using an actively managed fund, surely you would want to?
The blunt truth
The problem is that although active managers have the potential to limit the damage in a crash or correction, they rarely do in practice. The blunt truth is that, when markets head south, active funds tend to fall just as far as passive ones, if not even more so.
Evidence of this is provided in the latest “SPIVA” report from S&P Dow Jones Indices. SPIVA stands for S&P Versus Active, and it’s a regular scorecard that compares the performance of active funds in different countries with the appropriate benchmark. This latest scorecard focuses on fund performance across Europe, and the findings are eye-opening.
In theory, the first half of 2022, when both stocks and bond markets fell around the world, presented fund managers with an ideal opportunity to shine. But did they? The answer is an emphatic No.
Failure in all but one category
Most actively managed funds underperformed their respective benchmark in nearly every fund category the SPIVA researchers looked at. The relatively small Poland Equity category was the sole segment where a majority of active funds outperformed in the six-month period ending 30th June.
The performance of fund managers in the UK was spectacularly bad. A staggering 96% of UK large- and mid-cap equity funds underperformed the S&P UK LargeMidCap benchmark in the first half of 2022. The figure rises to 98% over the 12-month period to the end of June.
It’s the worst ever performance recorded by fund managers in any European country in SPIVA’s history.
There are two key lessons here. The simple lesson is that very few funds outperform the market in the long run, and it’s extremely difficult to identify in advance those that will do so. Yet most Irish investors are still using active funds and paying a significant premium for the privilege. They would be far better off using low-cost index trackers instead.
But there’s a second lesson that’s more nuanced than the first but arguably just as important. It’s this: active investing, when you study it in any detail, is actually very messy, and you never can be quite sure of exactly what you’re getting.
Why is that? Well, it’s because of a widespread phenomenon known as style drift. Put simply, style drift refers to fund managers who stray from the fund’s stated style, and it happens all the time.
Style drift in action
The UK provides an excellent example of style drift in action. For several years now, UK equity managers have “drifted” away from larger stocks to mid- and small-cap stocks. And because large caps have underperformed their smaller peers for most of that time, their performance has been pretty good.
But that has changed in the last year or so, and larger companies have produced significantly better returns than smaller ones. And that is precisely why UK managers fare so badly in the latest SPIVA report.
One of the big problems with style drift, therefore, is that it makes it very difficult to evaluate a fund’s performance or compare it with another fund’s performance.
Risk and return are related
Generally speaking, the higher the risk you take, the higher your returns are likely to be. As you might expect, smaller companies tend to be higher-risk than larger companies, and, as a result, they tend to produce slightly higher returns over the long term. So when a fund manager drifts away from larger companies to smaller ones, they’re increasing their expected returns, but they’re also taking more risk.
That’s why funds that invest in small-cap stocks as well as large-caps often produce higher returns than funds, like large-cap index trackers, that invest purely in large companies. In other words, relative to the benchmark index, their performance often looks better than it would with a genuinely like-for-like comparison.
Of course, the rotation back towards large companies over the past year or so has had the opposite effect for active UK equity managers and makes their recent performance look worse. If those managers with significant small-cap exposure were genuinely skillful, surely they would have moved into large-caps before the rotation occurred? Either way, the SPIVA data clearly shows that very few of them did.
A cheaper and neater alternative
To be fair to them, as long as they aren’t breaking any rules, fund managers are perfectly entitled to drift from one style to another. But is that what you really want?
The good news is that you don’t need to pay an active manager for exposure to smaller companies. There are low-cost passive, and broadly passive funds, that give you exposure to small-caps around the world. These provide a more efficient, reliable, transparent and cost-effective way to capture the small-cap premium than traditional active management.
Why have a messy portfolio, when, with the help of an evidence-based financial adviser, you can have a neat and tidy one that, on a properly cost-and risk-adjusted basis, delivers better returns?