Passive funds outperform actives this year- AJ Bell

Only a third of active equity funds, 34 per cent, outperformed a passive alternative this year, according to AJ Bell’s latest ‘Manager versus Machine’ report.

According to the report, active outperformance was particularly scarce in the US, Global, and the Asia Pacific regions. Longer-term data show that active managers outperformed passive machines in most sectors. However, passive funds have dominated the US and global sectors over the last decade, and these sectors now account for £270 billion of investor money.

About 800 open-ended retail funds in seven popular equity sectors were examined for this report. AJ Bell calculated the number of active funds outperforming passive funds in the same sector and compared the median returns for active funds in various sectors based on the primary share class. As a result of the closing or merging of underperforming funds over longer periods, there is usually a survivorship bias in the performance data. AJ Bell also calculated the median charges for active and passive funds across the seven equity sectors.

AJ Bell head of investment analysis Laith Khalaf says: “2021 has been a pretty grim year for active managers, with passive funds ruling the roost and delivering better returns for investors on average. Outperforming active funds were particularly sparse in the Global and North America sectors, which are hugely important for investors because they are two of the most popular areas for investment, accounting for £270 billion of investors’ money.

“In the North America sector, fewer than one in five active funds outperformed a passive alternative in 2021, and the picture is not much improved when looking over a ten-year period. Longer term underperformance from active funds in these sectors suggest there is a structural reason why relatively few funds outperform a passive alternative. This is no doubt partly down to the fact the US stock market is poured over by so many analytical eyes and so active managers naturally find it more difficult to find an edge. But the continued market domination by a small number of large tech stocks may also be feeding into the equation, reinforcing the implicit passive principle that big is beautiful, and punishing those who take a dissenting view with their portfolios.

“This issue has increasingly affected the Global sector too, seeing as the US stock market has grown to such an extent that it now makes up around two thirds of the world index. Global tracker funds therefore increasingly resemble US tracker funds, making it more difficult for active funds to compete in this arena while the US maintains its ascendancy. If the raging US bull market comes a cropper though, this performance differential could get turned on its head, seeing as the average global active fund is around 8 per cent underweight the US compared to passive peers.

“As ever, averages and aggregate data can’t tell the whole story, and individual investors do have the opportunity to improve their own lot through fund selection, both active and passive. For active investors this means picking seasoned fund managers who have proved their performance potential, or their ability to deliver a set outcome such as a high level of income or a low level of volatility, though of course there can never be a cast iron guarantee of future performance.

“For passive investors, fund selection entails picking funds that track appropriate market indices effectively, at the lowest price possible, as charges will be a key determinant of returns. In the UK sector in particular, there is still an awful lot of money invested in tracker funds that are nowhere near the competitive end of pricing, in some cases charging ten or twenty times more than the cheapest fund on the market, year in, year out. Over a lengthy period, those higher charges are going to eat into passive investors’ wealth.

“Many investors of course choose to mix and match passive with active strategies, and our performance analysis suggests where each strategy might be in its element. In particular, within the Global and US sectors, active funds have failed to bring home the bacon compared to index funds. That’s by no means true of all active funds and there are some leading lights of the fund management world with offerings in these areas, for example Baillie Gifford and Fundsmith.

“While the long-term performance numbers from the US and Global sectors look pretty damning for active investors as a whole, it’s worth bearing in mind that market performance in the last ten years has been heavily influenced by ultra-loose monetary policy and the digitalisation of the global economy. Should one, or both, of those trends moderate or even go into reverse, life might not prove so breezy for the passive machines that simply invest money according to the size of companies in the market.

“Active performance in the US and Global sectors has been particularly disappointing, but that may partly be down to the increasingly concentrated nature of the S&P 500, because the US stock market itself has become increasingly dominated by a small cluster of tech names. These tech titans are now the seven biggest companies in the US market, and by extension in the global market. While not all have prospered over 2021, as a group they have tightened their grip on the US stock market. Together they make up 27 per cent of the S&P 500, up from 24 per cent at the beginning of 2021.

“US active managers find themselves between a rock and a hard place when it comes to participating in the hegemony of the tech titans. In order to have an overweight position in these stocks, an active manager running a US fund would have to allocate over 27 per cent of their portfolio to these seven companies. That’s a pretty punchy active position to be imposed on a fund manager purely by market leadership. Even if an active manager were to hold the 27 per cent to maintain a market weighting in these stocks, that’s over a quarter of their portfolio that’s simply pegged to the market, which would actually be losing ground against a comparative tracker fund because of the higher charges associated with an active approach. On the other hand, any US active manager who had dared not to hold any of these stocks over the course of 2021, would have found themselves facing some uncomfortable questions around performance.

“The increasing concentration of large parts of the global stock market capitalisation in a limited number of companies operating in technology driven industries should be cause for concern for active and passive investors alike. The melt up in the US market has relied heavily on exceptionally strong performance from these few large tech stocks. Given their heavy weighting in US and global indices, a turnaround in fortunes for a relatively small number of companies could therefore inflict significant damage on the global stock market as a whole.”

“While the wide-ranging underperformance of active managers in 2021 tells us something about market conditions over the course of the year, such a short period of time can’t tell us too much about the long-term value of active management. Even for a skilful active manager, the question of performance over the course of a year would be little more than a coin toss. Looking over the longer term, active managers have done a better job than in 2021, though outperformance has still been scarce in the US and Global sectors. There is some survivorship bias in the numbers too, and while in theory this might apply to both passive and active funds, in reality it’s much more likely to positively skew returns in the active segment and can be expected to exert greater upward pressure on the performance figures the longer the time period under inspection.

“The fact that over 10 years only 56 per cent of active funds have beaten a passive alternative, despite a tailwind from survivorship bias, demonstrates that investors need to be picky when it comes to buying active funds, and perhaps the regions in which they choose to allocate to active managers. Around a third of the funds in our 2021 sample sit in the Global sector, reflecting its popularity amongst investors, and that means the fortunes of funds in this sector have a disproportionate effect on the picture for active and passive funds taken as a whole. Active funds in other sectors have fared considerably better though.

“Overall, it’s clear that Global and US sectors have been the place to be over the last ten years, and investors in underperforming active funds might take some consolation from the fact that simply allocating to these sectors has likely been more important in generating returns from fund selection in other areas.

“The UK has been a particularly good home for active managers, with the average active fund returning 134 per cent compared to 95.6 per cent from the average passive fund over 10 years, a significant differential that cannot easily be explained by survivorship bias alone. There are some other factors in this sector which can go some way to revealing why active managers have performed so well against passive alternatives though.

“The IA UK All Companies sector is home to a significant number of funds which focus on the midcap area of the stock market. Indeed, of the ten best performing UK funds over ten years, four explicitly target the FTSE 250 as their benchmark index, and many of the other top performing funds have a multi-cap approach which sees them invest heavily in small and mid-cap companies. Not only have small and mid-caps significantly outperformed the big blue chips over the last ten years, they are also a fertile hunting ground for active managers to pick out hidden gems, as they are not as well scrutinised by the wider market. The positive midcap effect on the outperformance of active managers in the UK is also exacerbated by the fact that some passive funds track the blue chip FTSE 100 index, rather than the wider FTSE All Share.”

“The UK All Companies sector is also one of the oldest, and that has some bearing on the passive funds that are available in this area too, with some higher charging legacy funds helping to lower returns across these funds as a whole. Whereas the cheapest UK tracker fund in the sector costs just 0.05 per cent per annum, there are a number of funds which cost over 1 per cent. When looking at performance for both active and passive funds, we have used median instead of mean averages in order to mitigate the effect of outliers like this within the data sets. However, inevitably there will still be some downward performance pressure from higher charging passive funds in the UK, compared to a sector like the US, where the lowest fund charge is also 0.05 per cent, but the highest is a much more competitive 0.29 per cent per annum.

“While the effect of mid cap performance and higher charging tracker funds do tilt the balance in favour of active funds in the UK, these factors are still present in the UK fund investment universe, and so are a fair representation of the investment opportunity set open to investors in UK funds.

“Looking at annual charges more broadly, on average UK active funds are typically offered at a lower price than most other regions and command a smaller premium over passive alternatives too. Combined with strong relative performance from active managers in the UK, this suggests that if investors do wish to invest some of their portfolio actively, the UK is a favourable place to do it.

“Charges on the most competitively price tracker funds have come down significantly in the last ten years, and so discriminating passive investors can expect to improve their lot by shopping around. Active fund charges have also become more competitive since the Retail Distribution Review prompted greater transparency in this market. Active funds are less commoditised than passive funds though, with managers competing not just on charges, but also on performance and volatility. Active investors may legitimately therefore choose to pay a price premium for a fund manager they have a high level of conviction in. Such considerations don’t carry much weight in tracker land, where index selection and price are the key components of investment decisions.”