Revenge of the active manager

By Buttonwood

ONE should always present both sides of the case. A recent briefing highlighted the rise of passive investing, exchange traded funds and "smart beta" and the threat they represent to active managers, those who charge higher fees because they say they can beat the market. And a column focused on a recent study showing that even experienced active managers cannot be relied upon to beat the market.

That column also referred to a version of a Vanguard study which showed, on the basis of one sector, that equity managers cannot be relied on to outperform. Of the 335 funds that were in the top quintile (20%) of the UK equity sector over the five years to the end of 2008, just 12.8% were in the top quintile in the five years to end 2013. By contrast, 24.5% were in the bottom quintile over the following five years; roughly speaking, you had double the chance of picking a dud as picking a winner if you selected a fund on past performance. (Some 23.6% of funds were merged or liquidated, a remarkable turnover by itself.)

Simon Evan-Cook of Premier Funds, a doughty defender of active managers, points out in a paper something that readers might not have gleaned from the Vanguard report. The five years to end 2013 were very good for active managers, probably because small and medium-sized companies (those not in the big indices) did well. The average UK equity fund outperformed L&G's UK index, one of the best-known trackers, by almost 18 percentage points. the L&G fund was 171st out of 241 funds in its sector. As Mr Evan-Cook writes

the simple implication of this is that, by sticking a pin in a list of UK equity funds, an investor was likely to get a better return than the tracker's.

There is a sort of acknowledgment of this on page 6 of the Vanguard report which says that active managers did very well in 2013 and shows, in a graph, that only around 40% of managers underperfomed the market over 5 years (i.e. the majority outperformed). But Vanguard argues that this outperformance would be eliminated were survivorship bias to be eliminated (bad funds tend to close down).

Having given active managers a hard time, it seems fair to point all this out. However, I don't think this makes much more than a dent in the Vanguard case. This is one sector over one period. Academics would accept that there weill be some periods in which active managers outperform, but those periods cannot be reliably predicted.

In part, this is down to maths. Much of the market is made up of professional fund managers who incur costs and charge fees; the index does not allow for costs. Therefore, it is unlikely that, over the long run, the average active manager can beat the index.

So pick an above average manager, you might say? Mr Evan-Cook's objections do not demolish the statistics shown above; performance is not persistent. We can know in retrospect that a few fund managers have outperformed but we cannot know in advance who they are. Indeed, if it were possible to identify such paragons, all the money would flow to them; incompetent managers would have no clients. But then we would be back to the mathematical problem of the average manager beating the average.

In other words, it is a game of probabilities. Picking a low cost tracker will not always be the best option over all sectors and all periods. But it will be, more often than not.