It seems a strange thing to say of a year that saw the collapse of one of the country’s most lauded fund managers, but 2019 was in one important sense a great time for active fund managers. Figures from Trustnet show that more than two-thirds of funds in the all companies sector beat L&G’s UK index fund. This represents a huge improvement on 2018, when less than 30 per cent did so.
So, what happened? Was there a radical shake-up of the fund management industry that attracted an influx of talent? Did managers discover a wonder drug that gave them stockpicking superpowers?
No, and no. The truth is more mundane, and overlooked by investors.
The key fact here is that the All-Share index weights stocks by their market capitalisation. This means that an index tracker must hold 90 times as much of Royal Dutch Shell (which has a market capitalisation of £177bn) as it does of a decent-sized FTSE 250 stock. And it must hold 60 times as much of HSBC and 50 times as much of BP as it does of that mid cap.
Which brings us to the problem. HSBC, BP and Royal Dutch – which together account for 17 per cent of the All-Share index – all fell last year. This dragged down returns on the index and on passive funds relative to those of active managers who were not so compelled to hold such underperforming megacaps.
Any investor who had picked stocks at random last year would have beaten the market with average luck, simply because most stocks beat the market. In this sense, active fund managers had a huge advantage: dumb luck was on their side.
Herein lies the big difference between last year and the year before. In 2018 big stocks outperformed smaller ones: the FTSE 100 outperformed the FTSE SmallCap Index by five percentage points. That meant that most stocks underperformed the market, which meant that most fund managers did so.
This pattern is perfectly common. In 2015 small-caps beat the FTSE 100 and most active managers beat the market, but in 2016 large stocks beat small ones and most active managers underperformed.
When big stocks beat little ones, active managers do badly. And when little ones beat big ones, they do well.
Which poses a question for everybody investing in active funds or picking stocks for themselves: will small caps continue to beat bigger ones?
Certainly, there are circumstances in which they do so. Economic upturns and improvements in investor sentiment typically see smaller stocks outperform.
These, however, are temporary cyclical phenomena that are reversed when sentiment weakens or the economy falters. Over the past 30 years, on average, small stocks have done no better or worse than the FTSE 100. This is consistent with Gibrat’s law, which says that growth should be independent of size. Yes, big stocks are vulnerable to all sorts of diseconomies of scale, one of which is managerial hubris. But they also have a degree of monopoly power that protects their earnings. And they got to be big by doing a lot right, so they have fallen into good habits, which should help them continue to thrive. Net, the pros and cons of big stocks over smaller ones balance out over the long run.
For me, this is a case for long-term investors to favour tracker funds – because in the long term active managers are unlikely to outperform, but are certain to impose higher charges – and these compound horribly over time.
Of course, this is wholly consistent with active managers continuing to outperform for shorter periods. If investor sentiment continues to improve, and if we get an economic upturn, 2020 could be one such period.
What seems odd to me, however, is that stockpickers and active managers rarely try seriously to identify in advance these conditions in which active management works or doesn’t, and so rarely switch between active and passive strategies. This suggests that active management might be more of a business model than a proper investment strategy.
