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Another mis-selling scandal?

This is because the Financial Conduct Authority has launched an inquiry into the fund management industry which might conclude that it has consistently charged investors too much for mediocre performance. This, says Andrew Lilico of Europe Economics, is "nothing less than a ticking time-bomb" because it might expose the industry to a wave of claims that it has mis-sold actively managed funds by "deceiving investors" into buying high-charging, poor performing funds.

A recent paper by David Blake of Cass Business School and colleagues shows the scale of the problem. They studied the performance of UK unit trusts between 1998 and 2008 and concluded: "the vast majority of fund managers in our data set were not simply unlucky, they were genuinely unskilled." They estimate that a typical investor would have been 1.4 percentage points a year better off in a low-cost tracker fund. This corroborates other evidence. Vanguard's Peter Westaway has found that "active fund managers as a group have underperformed their benchmarks". And researchers at Rice University have found a similar thing in the US. "We find little evidence that active funds outperform passive funds", they say, adding that risk-averse investors should prefer trackers because they offer less chance than active funds of badly underperforming the market.

Now, 1.4 percentage points might not sound much. But it compounds over time. Simple maths shows why. Over the past 20 years, the All-Share index has given a total return of 7 per cent a year. An investor in a tracker fund charging 0.25 per cent per year - by no means the cheapest - should therefore have seen £100,000 20 years ago grow to just under £370,000 by now. But the investor who lost 1.4 per cent per year relative to this would have seen his £100,000 grow to just £284,000. That's a loss of £86,000. Added up across thousands of investors, this is big money.

Let's put this another way. The Investment Association estimates that there is £491.5bn invested in equity unit trusts, only around 11 per cent of which is in trackers. If the other £437bn charges 0.8 percentage points per year more than trackers, then unit trust investors are spending £3.5bn a year in unnecessary fees. "From the point of view of individual investors, active investment is clearly a mistake", says Ugo Panizza of Geneva's Graduate Institute.

It's in this context that professor Malkiel's words could be so expensive for fund managers and financial advisers. He is no maverick. He's a former president of the American Finance Association and those words were published in the Journal of Finance, the most prestigious academic finance journal. Nor were they a new finding: the first evidence that active managers underperform the market was published way back in 1960. You could therefore easily claim that his advice was best practice from at least the mid-1990s onwards and that this should have been known by professional advisers. From this perspective, anyone who urged investors to buy expensive actively managed funds that did not subsequently beat the market could be accused of mis-selling by not following best practice. Hence the "time-bomb" that Mr Lilico describes.

So, what defence do active managers have? It is the case that, in the past five years, most of them have beaten trackers: for example, 174 of the 236 unit trusts in Trustnet's all companies sector have outperformed Scottish Widows' All-Share tracker. But this probably owes less to fund managers' abilities than it does to the pattern of stock returns. Small-caps have beaten large-caps during this time, which means that most stocks picked at random have beaten the index (which, remember, is capitalisation-weighted).

You can certainly argue that active managers perform a useful social function. Without them, stock markets would be informationally inefficient - or at least more so than they actually are - and so real economic activity would be distorted, with some companies investing too much and others too little. However, as Dartmouth College's Ken French says, this is an externality: it benefits us all, but the costs of making the market efficient are borne heavily and sometimes unwittingly by buyers of actively managed funds. Such buyers might wonder why they have paid for a benefit that the rest of us have got for free.

A better defence is that, in the past, active funds gave investors exposure to some market segments they could not otherwise easily obtain, such as emerging markets or a diversified basket of income stocks. However, the emergence of low-cost exchange-traded funds (ETFs) has removed this defence.

There is, though, another possible defence of mediocre funds. What matters are not just absolute returns but risk-adjusted ones; we make do with worse performance if an asset protects us from risk. Economists at the University of California at Irvine have found that, in the US at least, funds do offer some protection from risk. "Active funds perform better in down markets," they conclude. Lower average returns might well be a reasonable price to pay for this outperformance in bad times.

This point might broaden because there are other risks that might justify lower returns. For example, funds that do less badly than others in recessions might justify lower average returns because they protect investors from cyclical risk.

Perhaps, then, the case against mediocre fund managers isn't watertight. Nevertheless, they might face some interesting legal claims if the FCA's report proves damning. Like many interesting things, however, these would be best viewed from a distance.