The Rationale Behind the Active-to-Passive Rotation

Are investors sacrificing performance by moving from active to passive funds?

Last year, £23bn was pulled from equity mutual funds and ETFs by UK investors—the second highest redemption on record, surpassed only by 2022. This was a tale of two strategies, however, as actively managed equity funds lost £24.13m while index-trackers gained £525m—modest, but positive in the face of huge headwinds. This trend remained in 2024, as active equity funds shed £9bn while their passive peers enjoyed inflows of £8.54bn in the first half of the year.

Passives have grown from 7.1% of UK mutual fund and ETF equity assets in 2004 to 26% in 2023. While that’s a seismic shift, it still lags the US market, where the equivalent figure for January 2024 was 55%.

While it’s certainly been the cheaper option—the average total expense ratio for actively managed funds is 1.14%, while for passives it’s 0.318%—has it been the better one? We compared the average returns of index tracking and actively managed Equity UK funds over 10 discrete years between 2014 and 2023 against their benchmarks (chart 1).[1]

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

Source: LSEG Lipper

Active funds outperformed on four out of 10 years. The average annualised outperformance over those four years is 2.75 percentage points, while the average underperformance over the remaining six is 3.33 percentage points, skewed by the hefty underperformance in 2022 of 8.35 percentage points. This is the year when inflation roared back. While that drove a locomotive through fixed income returns, equity sectors that had thrived in the low-rate environment prevalent since the Global Financial Crisis were also negatively impacted. That’s true for both active versus passive funds, but active managers have the ability to see the train coming and step off the tracks, in the way that passives don’t.

Yet, in this instance, that’s not what happened.

Year on year, this 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.

Is active better with bonds?

There is also a similar and seemingly accelerating shift happening in fixed income. Last year active bond funds suffered redemptions of £7.61bn, while their passive peers took £18.17bn. For the first half of 2024, those figures are -£12.87bn and £22.01bn, respectively.

I’ve heard one bond fund manager argue that active management in this asset class has inherent advantages absent in equity markets. Bond indices are weighted relative to the amount of outstanding debt, so in the corporate bond market, indexed investments are ploughing ever more into the most debt-bloated companies. It’s been described as akin to Soviet planning, where the most bloated, inefficient entities get the most resources. Active managers have the capacity to depart from this, overweighting less indebted, healthier companies, while avoiding those sluggish debt-gorged beasts.

Sounds plausible, but do the numbers back it up?

Chart 2: Bond fund returns relative to benchmark, 12-month discreet periods

Source: LSEG Lipper

As in the equity analysis, I’ve taken a 10-year period from 2014 to 2023 and looked at average performance after charges. The bond fund universe in chart 2 is comprised of funds from the Bond EUR Corporates, Bond EUR High Yield, Bond GBP Corporates, Bond USD Corporates, and Bond USD High Yield Lipper Global Classifications, as these had enough primary share classes registered for sale in the UK to make meaningful comparisons between active and passive performance.

Active managers outperform passives on three out of 10 years, most significantly in 2020, by 43 basis points (bps). However, passives outperformed active by the largest margin in 2022, by 120 bps. The average annual outperformance of passive over active was 37 bps. In each of the five Lipper Global Classification, active managers underperform passive over 10 years relative to benchmark.

The logic of passive outperformance

Charges matter. Whether bond or equity, active management, as the more expensive option, will underperform on average over the long term. Mathematically, this must be so. The market return is no more than the sum of all its participants, so net performance is that minus charges: the greater the charges, the greater the average underperformance.

But, of course, that’s the average: actual returns are widely distributed. The top active performers will always leave the trackers way behind.[2] But the converse also holds. For instance, looking at the last five-year rolling period of equity fund returns, 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. Over the full 10 years, that latter figure is 110.61 percentage points below benchmark.

Of those active bond funds with a full 10-year track record, the top one beats its benchmark by a cumulative 71.84 percentage points. But the inverse is also true, as the bottom active fund underperformed its benchmark by 57.79 percentage points. Given the relative volatility of the asset class, it’s perhaps no surprise that both funds are Bond USD High Yield.

There are a few periods where passive funds outperform their benchmarks—something that, after costs, would seem unlikely. However, there are several reasons why passive returns can diverge from the indices they track, such as the method of replication, where use of swaps or sampling can lead to divergences.

There is also the argument that the probability of active outperformance increases with greater market volatility and the dispersal of security returns. Some research backs up this thesis. For example, one research paper found: “as return dispersion increases, the percentage of outperformers also increases”. That could argue in favour of tactical shifts from passive to active in periods of higher volatility, but timing that can be (to say the least) tricky. Also, as we saw with the example of higher volatility in 2022, in the words of the song, “it ain’t necessarily so”.

Fund selectors can stay cautious and stay passive—that’s certainly the way the market is trending. Or they can use metrics such as Lipper Leaders scores to identify funds more disposed to deliver alpha. Nevertheless, as costs become ever more imperative, the drift to passives seems set to continue.

[1] UK registered for sale Equity UK funds, selecting by primary, unhedged share class, return net of costs.

[2] This holds true for broad market indices. As the range of induces increases, it’s possible to find niche passive funds that will shoot the lights out as their sector or factor plays go into the ascendancy.

This article first appeared in Personal Finance Professional.