Where active management works

“Index tracking has failed UK stock market investors.” So thundered one of the Investors Chronicle’s more forthright recent headlines, and not without justification. The relevant article, authored by the IC’s Phil Oakley, laid bare just how discouraging recent history has been for the FTSE All-Share and the passive funds that track it.

Investors are more than familiar with the dismal recent performance of a market many now love to hate. A horrendous pandemic, the resulting swathe of dividend cuts and those ever-present Brexit concerns mean that even after several weeks of euphoric, vaccine-fuelled price gains, the FTSE All-Share is still sitting on a double-digit loss for 2020, as of late November. Yet the past two decades have done few favours for UK equity trackers, either. As the IC associate editor concedes, the FTSE All-Share has actually outstripped inflation over a 20-year stretch – but “only just”. Good UK stockpickers, by contrast, have shown that rich gains can still be made from such unloved markets, provided one is picky enough.

This matters because in many cases the shoe is on the other foot when it comes to stockpickers versus trackers. Active fund managers are often rightly hounded for charging hefty fees while failing to consistently beat the index, especially in promising markets such as the US. In such a scenario, paying next to nothing for a cheap index fund has increasingly seemed like a no-brainer.

Even the most famous and celebrated stockpickers have furthered the perception that passive is an easier route to success than picking stocks or fund managers. The outcome of Warren Buffett’s infamous 10-year, million dollar bet – in which he challenged US advisory firm Protégé Partners to assemble five “fund of funds” that could outperform the S&P 500 in the decade to 2018 – likely settled the debate for many. Having deployed a host of seemingly elite hedge funds run by the cream of the investment crop, each fund of funds portfolio resoundingly failed to beat the humble US equity tracker.

Some decades on from the inception of the original index fund, passives of all stripes are a common sight in many a portfolio. Investment Association (IA) figures show that UK investors had £239.4bn sitting in tracker funds at the start of October – a figure that does not account for the waves of money sloshing around in the exchange traded fund market. Trackers commanded 18.1 per cent of the money kept in open-ended funds by UK investors by October this year, up from 6.6 per cent at the end of 2010.

But as the recent history of UK equity markets might suggest, passive is not always the best call for even the most cost-conscious or hands-off individual. Many investors already mix active and passive funds as a matter of course. Identifying just how well active holds up in different markets can teach us valuable lessons and potentially guide some important investment decisions.

An assessment of where stockpickers have beaten the benchmark and the extent to which they have done so, outlined in this article, serves as an instructive snapshot with some telling results. And while the findings do not provide an overwhelming case for or against active, some will add important nuance to arguments where a black-and-white mentality might normally dominate.

Neither is the dataset free of idiosyncracies: the IA sectors we pit against an index can include funds with a variety of different approaches, while not all time horizons are the most reliable. Although we have explored 10-year figures in our initial analysis, we will ignore these in favour of the three and five-year numbers. Running the data over a full decade introduces an element of “survivorship bias” where weak funds fail and the more successful names are left standing, distorting the results and giving a misleading impression. Our approach to crunching the data and any other quirks to be aware of are set out in the 'Explaining our methodology' box.

Where active works

Let us first chalk up an easy victory for stockpickers: funds in the IA’s small-cap equity sectors have shown good levels of success against the relevant benchmarks. The case often made by the active management industry, that companies further down the market cap scale are less thoroughly covered by research and therefore more likely to be mispriced, appears to be holding true in at least some parts of the world.

As of the end of October, more than 80 per cent of the funds in the Japanese Smaller Companies sector came out ahead of the MSCI Japan Small Cap index over one, three and five years. Those who feel as dismayed as Phil Oakley by the state of UK equity trackers will take consolation from the success rate of funds in the UK Smaller Companies sector. More than 80 per cent of the sector’s constituents were ahead of the Numis Smaller Companies ex Investment Trusts index over three and five years.

The options available to small-cap enthusiasts can admittedly be limited: the Japanese Smaller Companies sector consists of just seven funds. Investors should also note that the small-cap success story does not transcend all boundaries. Just half of the funds in the European Smaller Companies sector beat the chosen benchmark over three years (and fewer over five). US small-cap managers fared better, but with less obvious success than their UK and Japanese peers.

As always, readers should remember that going down the market cap scale can bring bigger risks as well as greater potential gains, even within the diversified format of a fund. The speed with which things can go wrong was recently illustrated by the suspension of trading in the Downing UK Micro-Cap Growth fund (GB00B7SB5C00) after a year of weak performance, and investor outflows that saw the fund’s asset base shrink to just £8.4m. Caution aside, those advocating the case for active when it comes to smaller, less widely covered companies do have a leg to stand on.

How the main sectors fare

The results are sadly much less decisive when it comes to funds with more of a generalist bent. But the findings might still provide less gloom and doom than some had anticipated. Silver linings can be found, and some useful lessons learned.

Stockpickers in Japan are again ahead of the pack, but the field is much less competitive than in the small-cap space. Some 60 per cent of funds in the IA Japan sector come out ahead of the Topix index over one and five years, with this proportion falling slightly over a three-year stretch.

The figures are far from convincing elsewhere. While they hold up slightly better in the shorter term, UK and European equity funds only tend to beat the index around half the time over three and five-year periods. This casts serious doubts on one logical assumption – that active funds enjoy greater success in “bad” markets, where the composition of an index exposes passive investors to plenty of risks but good companies can still be found by selective investors.

The message is somewhat mixed when it comes to stronger markets, too. Yes, Asian and emerging market stockpickers have clearly struggled against an equity universe that is rapidly gaining momentum. But, at the risk of dishing out faint praise, some might also argue that funds in the IA North America cohort have done less badly versus the S&P 500 than expected.

Global equity funds have had their own share of the pain, registering the lowest success rate over five years. As in some of the other regions, a portion of the blame can be placed on the composition of indices and the fund sectors themselves.

What does this tell us about picking funds?

“Career risk” is a common problem for active managers everywhere, and one that can cause serious issues for their customers. Some active managers, afraid of diverging too much from the market, getting it wrong and promptly finding themselves out of a job, will seek to safeguard their career by staying relatively close to a benchmark index to limit underperformance. This rarely results in an optimal outcome, and is one of many factors cited as a driver of underwhelming active returns. Many of the most successful active managers of recent years, from Nick Train to Terry Smith, have moved in the exact opposite direction by deliberately building concentrated portfolios of their favourite stocks.

However, when it comes to specific markets in which active managers appear to have a better or worse chance of success, these odds can also depend on the composition (and success) of the index, as well as the tendencies of stockpickers. This can be seen to some extent in our results.

Active managers in Asia and emerging markets are not obviously any less skilled than their peers, but the composition of the underlying market does create serious problems for stockpickers when indices are on the rise. Asian and emerging market indices are both marked by a significant weighting to China – a runaway market of 2020 – as well as heavy exposure to Tencent (HKG:0700), Alibaba (HKG:9988), Samsung (Korea:005930) and Taiwan Semiconductor Manufacturing Company (TPE: 2330). Active managers often struggle to build enough exposure to these names to match the index weighting – and going overweight on these market leaders can potentially put them in breach of diversification rules. US investors will recognise these woes, given the heavy presence of Microsoft (US:MSFT), the FAANG stocks and other tech names in their market. Simply put, index concentration makes it hard to outperform when the hottest stocks and markets have momentum behind them.

Global equity funds share some of the concentration problems seen in the US and Asia. US stocks represented two-thirds of the MSCI World index at the end of October, with no fewer than five of the US tech giants among its 10 biggest constituents. In recent years global equity fund managers have deviated from the main market at their peril.

The composition of the Global cohort itself may also spark some debate about which funds might be fairly compared with mainstream indices. The sector is home to multiple thematic funds (such as Morgan Stanley Global Brands (LU1418832595)), as well as numerous ESG offerings and some names with especially niche remits – take Pictet Water (LU1002871454) as one example. Some might argue that not all these products should be judged against a mainstream index. A counterclaim runs that such distinctive approaches target promising investment themes that can hopefully beat the main market over time.

Active managers’ own habits should also be kept in mind when we consider how funds fare relative to their home markets. UK equity managers, for example, have often tended to take an overweight position in mid-cap stocks rather than blue-chips. And while those with such preferences do sit at the top of the table over the five-year period in our analysis, from Chelverton UK Equity Growth (GB00BDB4WW75) to CFP SDL UK Buffettology (GB00BF0LDZ31), ASI UK Mid Cap Equity (GB00BDD9P541) and Marlborough Multi-Cap Growth (GG00BKM3ZZ63), many of the sector’s winners and losers can actually be singled out by investment style. In a cheap, unloved market that has only become less popular, deep value funds such as M&G Recovery (GB00BG03Y868) are still a long way from vindication, while quality-minded names like such as Buffettology fund continue to prosper.

For any underperforming manager or market, a contrarian case can always be made. Will the value rally that began in November keep up over the longer term? Perhaps. Will big tech stocks in Asia and the US ultimately falter, making way for investment strategies less reliant on today’s market leaders? Also plausible – but many have wrongly made such bets, to their own cost, in recent years.

The consistency dilemma – and a ray of hope

While the findings might shed some light on where life has been kinder to active managers, the search for consistent outperformance is more pressing – and something that further narrows down your choices. A fund manager may have a good run, but outperformance is not guaranteed in different circumstances.

Our master table (see below) looks to tackle this issue, and does at least offer some consolation from very recent history. Because the extreme volatility of 2020 might unduly influence the numbers, we also looked at how active fund sectors fared in the five years to 2020. The results suggest that the findings remain largely unchanged – although the five-year numbers look less impressive for the IA Japan sector and somewhat better for Asian equity managers.

If consistency is hard to come by over a longer time period, the good news is you don’t need many reliable active managers to give you an edge. And a handful of names in different markets have demonstrated a good level of consistency, even if they don’t win out every single time.

This applies across different geographies. Rathbone Global Opportunities (GB00BH0P2M97), for example, has outperformed the MSCI World index in seven of the 10 calendar years leading up to 2020 (2010-19) – as well as coming out ahead this year. Baillie Gifford Pacific (GB0006064199) beats the MSCI AC Asia ex Japan index in eight of those 10 calendar years – a success rate shared by Legg Mason IF Japan Equity (GB00B8JYLC77) when compared with the Topix index.

In the UK, Liontrust Special Situations (GB00BG0J2795) is ahead of the FTSE All-Share in nine of the 10 years. On the continent, JPM Europe Strategic Growth (LU0119091675) beats the FTSE Europe ex UK in eight of those years.

All of these examples spring to mind before we even start to consider the stars of the investment trust sector, where strong NAV returns can be rewarded with big share price gains. Consistency can still be found by those who look carefully enough.