There are two key types of investment fund management: ‘active’ and ‘passive’. At first glance, ‘active’ management sounds like the best option. Surely ‘passive’ management will miss golden opportunities?
Don’t be fooled by the marketing departments of these investment houses. Blindly turning over your money to an active fund manager could be a bad idea for two reasons.
Firstly, the issue of the high fees charged by active managers: on an investment of £100,000, you can expect to pay up to £1260 per annum for an active Global Equity Fund whereas a passive Global Equity Tracker Fund might cost you as little as £200***. Imagine the effect that avoiding these charges alone would have on the longer term value of your investments.
Secondly, most active managers actually underperform the market in any given year. Those few managers that do outperform in one year are highly unlikely to repeat the feat the next. Betting on which manager gets lucky is not smart investing. A report* from Standard & Poor’s indicates that 74% of actively managed US equity funds underperformed the market over the past three years. This follows an earlier report** which showed that fewer than 5% of all top-performing funds remain in the top-quartile two years later.
Closer scrutiny of the reports reveals the extent of underperformance by active managers. All domestic funds have lagged the S&P Composite 1500 by 23% over the past five years. All large-cap funds have returned 52% less on average than the S&P 500 over that same time frame. Most active managers are simply not justifying their fees.
Using track record to identify a winning manager isn’t straightforward either: investors may have thought Bill Miller was unbeatable in 2005, after his fund had outperformed the market for 15 consecutive years. But a rude awakening lay in the next five and a half years, when Miller’s Legg Mason Value Trust lost 36%. Meanwhile the S&P 500 gained 13%.
There are almost no records of consistent outperformance by actively-managed funds. Of the 558 mutual funds in the top-quartile of performers in 2009, only one remained in the top-quartile for each of the next four years.
So attempting to pick the next ‘hot’ fund manager is less about investing and more akin to gambling – with the odds heavily stacked against you.
However, an active manager does have the opportunity to deliver a return above that of the markets – and this will always present a lure for investors. Passive management (without the use of leveraged products) is not going to “beat” the market; it can only match it.
Taking all the evidence into account, the obvious conclusion is to get your asset allocation right, reject the high-cost incompetence of active fund managers and buy exchange traded funds (ETFs) or index trackers instead. This wisdom has already been encapsulated by one of the world’s greatest investors, who tells his adoring shareholders that when he dies, he will recommend that his widow leaves nine-tenths of the money made from a lifetime of value investing – in a fund that tracks the S&P 500 index:
“I believe the long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers,” writes Warren Buffett.
“Some sectors are more suited to active management – commercial property, technology, or smaller emerging market economies, where expert knowledge can arguably seek out value,” says La Playa’s Henry Metcalf. “But on the whole, my view is that Asset Allocation is key, and being in the right asset class at the right time is what is important, not the past performance of a fund manager who is having a good run.”
This document does not represent financial advice and you should seek independent financial advice before making any investments. The value of your investments can fall as well as rise and you may not get back the full amount you invest, whether investing in an active of passive style.
If you’d like advice on your investment portfolio, contact La Playa Wealth on 01223 200650.
* Forbes Magazine “great speculations”, July 2013
** Standard & Poor’s Persistence Scorecard, July 2013
*** This is Money, May 2014