Active Fund Managers Keep Underperforming the Broader Market

How do we measure the causes of success? Hard work and skill are essential, but luck also plays a part. However, no one can stay lucky forever. To separate the competent from the blessed, I like to think that consistent performance over time flattens out the variance of fortune.

So, when we consider the long-term performance of active fund managers in the UK and the US over the last decade, a worrying trend emerges. According to S&P Global’s Indices Versus Active (SPIVA) scorecard, most equity fund managers fail to beat the market. And this is not a blip. With the odd exception, this has been the state of play ever since the SPIVA scorecards were first published in 2002.

Active Fund’s Poor Performance

Consider this:

The last SPIVA scorecard showed that 69.33% of UK equity fund managers underperformed the S&P United Kingdom BMI Index over the past decade.

In the US market, the picture is even bleaker: 87.2% of all active funds underperform their benchmark between 2005 and 2020.

During the COVID-19 pandemic crash and the early stage of the recovery, things weren’t much better. According to research published by the University of Chicago, almost 3 in every four active funds underperformed the S&P 500.

This sustained underperformance is a worry for pension investing fund managers. When discussing active vs passive funds, the common refrain is that active funds are perfectly positioned to take advantage of the market in times of significant volatility. However, these figures blow that argument out of the water.

Call me old fashioned, but if the entire premise for active funds is that they outperform passive funds, I’d expect that to happen more than half the time.

The Reasons Why Active Fund Managers Are Failing

While on the one hand, these poor results are shocking; on the other, it’s not entirely surprising. There are clear reasons for the poor performance of active funds.

Since the 1960s, the financial markets have undergone a process of professionalism that has resulted in a hyper-educated, hyper-competitive industry. Portfolio management is a zero-sum game that requires fund managers to out-skill other fund managers to make a profit. The result? Your average active fund manager doesn’t have an edge in their market.

In a less professional or less informed market, active fund managers were able to triumph. But now — as evidenced by the SPIVA scorecards — being one of the 15-25% that outperforms passive funds is incredibly tough.

Long-Term Problems

Additionally, there are drawbacks to active funds that limit how conducive they are to the ups and downs of long-term success. Long-term stock market success often requires the will to hold on to a poorly performing but high potential stock in the short term. However, it is easy to lose investor confidence — or your fund manager job — during these downswings.

Additionally, as pointed out by this research, funds that do outperform their benchmark over 15 years spend 60-80% of that time underperforming. These statistics require an iron will and the understanding of investors.

I say all this not to make it seem as if active fund managers are buffoons who are so incompetent that they are failing to beat the market — although that is an opinion held by researchers like Cass Business School’s David Blake.

On the contrary, these are smart people stuck inside a tough trading discipline. But whatever the understandable causes, their suitability for good pension investing must be called into question.

How Active Fund Managers Mitigate Risk

Another explanation for this chronic underperformance is detailed in Rob Isbitts’ excellent Forbes column. He speculates that the real reason active fund managers can’t outperform the S&P 500 is that a) they are not trying to b) if they did, they’d be out of business.

Isbitts explains that risk management is the main reason for active funds underperformance and makes the point that active fund managers are averse to the exposure of taking a position of the entire index. While this is an interesting point, he admits that indexing is cheaper and has performed well over the last 15 years.

Other Factors For Underperformance

Some of the other factors that affect active fund performance are fees and taxes.

Taxes

Active funds need to time the market to turn a profit. Buying and selling incur transactions costs that affect the fund’s returns. Additionally, profits lead to capital gains that are passed on to the shareholder.

Fees

Active funds have fees that eat into the returns. Fund managers charge 1-2% per year in management fees, compared to 0.1-0.2% for passive indexing. Additionally, sales charges can apply when you buy or sell the fund, frequently totalling around 4-8%. These charges compound over the years and negatively affect returns.

Solution

Fed up of what I have seen for decades now, having written about the problem in my Financial Times columns and books, I decided to launch a campaign to teach people how to invest for themselves - www.campaignforamillion.com - and give them free training to do so.

And can you teach people? Yes our interviews show you can.

Alpesh Patel OBE

www.campaignforamillion.com

www.alpeshpatel.com