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March 19, 2024

Have Equity Investors Been Right to Rotate from Active to Passive?

by Dewi John.

Last year, UK investors redeemed £23bn from equity mutual funds and ETFs—the second highest on record, surpassed only by 2022. However, this doesn’t tell the whole tale, as actively managed funds shed £24.13m while index-tracking funds saw modest inflows of £525m.

This reflects the growth in passive assets across the market, which have grown from 7.1% of UK mutual fund and ETF assets in 2004 to 26% in 2023.

Has this been the right move? I used Lipper for Investment Management analysis to compare the returns of index tracking and actively managed Equity UK funds between 2014 and 2023 against their benchmarks, over discreet annual three-year and five-year rolling periods (charts 1, 2, and 3). The universe was UK registered for sale funds, selecting by primary, unhedged share class, with calculations done net of costs.


Chart 1: Equity UK returns relative to benchmark, 12-month discreet periods

Chart 2: Equity UK returns relative to benchmark, three-year rolling periods

Chart 3: Equity UK returns relative to benchmark, five-year rolling periods

Source: LSEG Lipper


On an annual basis, active funds outperformed on four out of 10 years. On a three-year rolling basis, they outperform on three out of seven periods. On a five-year basis, they outperform on three out of five.

However, on a 12-month basis, the average outperformance is 2.75 percentage points, while the average for underperformance is 3.33 percentage points, skewed by the hefty underperformance in 2022 of 8.35 percentage points. On a rolling three-year basis, those figures are 4.41 percentage points outperformance versus 6.69 percentage points underperformance; for five years, average outperformance 2.02 percentage points versus 6 percentage points underperformance—again, skewed to the downside by the 2022 figures.

This all adds up. Over 10 years, index tracking funds underperformed their benchmarks by a cumulative 5.7 percentage points, whereas their active peers were 10.38 percentage points below benchmark.

Taking the five-year period to the end of last year, of a universe of 134 funds actively managed funds active over the period, just 45 outperformed their benchmarks net of charges. Actively managed funds underperformed their benchmarks by a cumulative 5.44 percentage points, while their index tracking peers did so by 2.4 percentage points.


Volatility, dispersal, and performance

Received wisdom is that periods of greater volatility and stock dispersal is when active managers earn their spurs. There is some support for this. One research paper found:

The arithmetic of active management dictates that when the performance of all investor groups is properly accounted for, exactly half will outperform a total market index before costs. After research and transaction costs, fewer than half will outperform. Thus, the percentage of all actively managed funds that beat the market in any period is unrelated to market efficiency. Rather, it is determined by the magnitude of return dispersion around the mean and the costs of active management. We show that as return dispersion increases, the percentage of outperformers also increases. (emphasis added)

Last April, I did some of my own number crunching on US, global, UK, and emerging market equity funds over a 20-year period, and found that:

If the thesis is true [that active manager performance improves in periods of higher volatility], outperformance in periods of high dispersal will be indicated by a positive correlation between outperformance and standard deviation. The correlation is positive across three of the four we looked at, varying in strength by index.

The strongest correlation is for the S&P 500 TR (0.43). That’s not a strong relation, but with many other factors impacting on performance, it would be odd if it were. It is, however, positive and not insignificant… Next comes the FTSE 100 TR (0.34)… and then MSCI AC World TR USD (0.27).

In this current, UK-only, analysis, the situation is more ambivalent. The two years when the annualised 12-month standard deviation is highest—2020 and 2015—are when active funds have not only beaten their benchmarks, but beaten them by the largest amount: by 3.46 and 4.1 percentage points, respectively. Nevertheless, the year with the third highest volatility, 2022, is when active managers performed worst relative to benchmark, at negative 8.35 percentage points.

Overall, on average, active management, as the more expensive option underperforms, as logic and Professor Sharpe dictate it must. But, of course, that’s the average, which no one gets, and actual returns are widely distributed: pick a fund at the top end of the distribution, and you’ll be a happy (or happier) investor; pick the wrong one, and you’re down a lot more than the broad market. For instance, looking at the last five-year rolling period, while the top fund beat its benchmark by a juicy 46.94 percentage points over the period, the greatest underperformer was down by an even more eye-watering 47.48 percentage points. And over 10 years, that latter figure is 110.61 percentage points below benchmark. Without naming names, that’s a special situations fund. Special—but not in the way you would want.

Overall, then, the rotation has made sense. Of course, the top active managers belie this. And, while many think they can identify these, someone is picking those underperformers—as, again, Sharpe 101 says they must. It’s likely that this logic will keep driving the move to passive.

This article first appeared in Investment Week.

LSEG Lipper delivers data on more than 360,000 collective investments in 113 countries. Find out more.

The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided 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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