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April 11, 2016

Monday Morning Memo: Softly Spoken Active Funds

by Jake Moeller.

Jake Moeller argues that the benefits of the active funds industry need to be articulated more strongly by its exponents.

The active versus passive fund debate evokes considerable passion among investors and analysts alike. If you type the topic into an Internet search engine, you can find yourself surfing for many hours garnering interesting views and opinions on the subject, ranging from serious and controlled academic studies to more anecdotal takes. Perhaps somewhat surprisingly, the subject also gets a lot of coverage in social media, with performance data and news items often commented on and redistributed with as much gusto as any celebrity intrigue.

Passive & Active – a differing tone

What strikes me in the publicly available commentary is that the proponents of passive management are considerably more vociferous in their views and more critical in their tone than the advocates of active management. There is a proselytising fervour within the passive camp that constantly cites the number of active funds that don’t beat their index, charge exorbitant fees, are closet trackers, or are generally out to fleece the unwary investing public. The active camp seems to be beholden to a quiet and perhaps uncomfortable diplomacy: there is room for both active and passive, investing is a broad church, and other similarly vague platitudes.

As an ardent proponent of active fund management, I’ve often wondered why its voice is so restrained. I understand that some fund houses such as BlackRock have a considerable exposure to both camps and can’t be seen to be undiplomatic. Many active fund groups perhaps feel constrained by modesty when they have a star fund, knowing there is always a risk its style could fall out of favour. Active fund groups perhaps recognise the asymmetry in the way investors digest their news flow. The regular lists that name and shame underperforming funds often generate more headlines than does a comparable announcement of winners at a fund awards ceremony.

The publication by S&P Dow Jones Indices of the SPIVA Europe scorecard in March 2016 is the most recent study igniting another round of active bashing. Prima facie, the headline doesn’t sound good: according to S&P, “the majority of euro-denominated active funds” invested in European equities underperformed their benchmarks over the three-, five-, and ten-year periods (to December 2015). Furthermore, these results came in what S&P describes as “ideal conditions in which active managers might be expected to outperform.” The S&P analysis reveals that for the U.S. market 99% of European managers failed to beat their benchmarks over ten years, while for the typically assumed inefficient emerging markets, 97% of European managers failed to beat their stated benchmark over the same period.

Active fund statistics in another context

Such statistics are certainly provocative, but they are not necessarily damning for all, and they certainly shouldn’t be justification for an investor to ignore active management. Anybody who believes in active management should be aware that funds can underperform a benchmark; styles fall out of favour, fund managers make the wrong decisions, markets are unpredictable. Investing in active funds requires considerably more background research and ongoing due diligence by an investor, and yes, it’s more expensive. However, by undertaking research into prospective funds investors can eliminate the perennial underperformers and considerably increase their chances of picking a winner. The fact is that not all the funds in a study sample have equal interest by investors. Aggregated data don’t reflect the experience of all investors.

It is the attraction of excess returns that drives investors into active funds, and the rewards for selecting a good active fund remain substantial. This opportunity simply doesn’t exist with a passive option, whilst the comparable risk of capital loss still does. Many studies such as that by S&P compare funds against stated benchmarks. I find it more useful to look at the efficacy of active versus passive fund options by comparing their performance within a classification scheme or peer group. This allows net-of-fee comparisons with passive options:

IA UK All Companies

Looking at the IA UK All Companies sector for the year ended December 31, 2015, the three-year opportunity cost of investing in the best performing broad-based tracker fund (Scottish Mutual UK All Share Acc) instead of the best active fund (Old Mutual Equity 1 A GBP) was a whopping 64 percentage points.

Over five years (to December 31, 2015) this opportunity cost was reduced, but the best performing active fund (Neptune UK Mid Cap A Acc GBP) beat the best performing tracker option (HSBC FTSE 250 Index Inc) by 56 percentage points. Indeed, in the IA UK All Companies sector to December 2015 over three years, 68% of all the active funds beat the highest ranked broad-based tracker fund, and over five years (to the same date) 62% of all active funds in that sector beat the highest broad-based tracker fund.

IA Europe ex UK

Looking at the IA Europe ex UK sector for the year ended December 31, 2015, the three-year opportunity cost of investing in the best performing broad-based tracker fund (Vanguard FTSE Dvlpd Europe ex-UK Eq Index GBP Inc) instead of the best active fund (Man GLG Continental European Growth Ret Acc A GBP) was 46 percentage points.

Over five years (to December 31, 2015) this opportunity cost actually increased, with the best performing active fund (again Man GLG Continental European Growth Ret Acc A GBP) beating the best performing tracker option (again Vanguard FTSE Dvlpd Europe ex-UK Eq Index GBP Inc) by 56 percentage points. In this sector to December 2015 over three years 64% of all the active funds beat the highest ranked broad-based tracker fund, and over five years (to the same date) 65% of all active funds beat the highest broad-based tracker fund.

While these numbers do not include exchange-traded funds (ETFs), they certainly show that for medium-term periods to December 2015, active funds more than held their own against tracker options for these sectors. This is an interesting counterpoint to the findings of the S&P study.

Long-term flows support active funds. For now…

Studies such as the S&P report often prompt a storm of commentary and usually bad publicity for active funds, but what is the fund flow reality? Lipper’s analysis reveals that ETFs and passive funds have rarely had above 10% of the total flows into all European mutual funds in recent years (reassuring perhaps for the active fund groups).

However, 2015 was in fact one of the best years for passive investments in Europe, with nearly 40% of fund flows moving into passive options. Although something was revealed in that passive composition–consider the ETF flow component in periods of crises (2008–GFC, 2011–Europe, and 2015–China wobble), it is probable that investors were more concerned about liquidity events rather than the active versus passive debate. But, if we see these types of numbers again for 2016 or 2017, some alarm bells should certainly ring for active fund managers.

Figure 1.  Fund Flows by Product Category (in €bn)

Source: Thomson Reuters Lipper

Source: Lipper

A single published study is unlikely to exacerbate flows away from active managers toward passive funds, and if it encourages some retail investors to ask questions of their financial advisors and fund groups, then that’s a good thing. However, there should be more concern about the cumulative effects of these news flows. The passive voice is getting louder. Online “pactivists” (passive-activists) are increasingly less diplomatic and are prepared to use any study or finding against their active colleagues in order to win market share.

Bringing the active voice out

There are of course vocal supporters of active funds and a number of supportive academic studies. Practitioners such as Chelsea Financial Services and Square Mile Research back their fund selection credentials with evidence, as do a number of other fund selectors. Orbis Investment Advisory has been prepared to put its head above the parapet with an elegantly concise paper “Orbis – Active Management: A Practitioner’s Perspective,” and there are a number of multi-managers who illustrate the benefit brought by active funds to their portfolios.

It is, however, the active fund groups themselves that need to become more assertive, either individually or through trade organisations such as the Investment Association. The diplomatic language adopted by active fund houses in the face of an increasingly innovative, dynamic, and noisier passive industry harkens back to a different time. If, as I firmly believe, active funds are a force for good in the investment industry, they ought to shout louder.


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Disclaimer: 
This material is provided for as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.

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