In contrast to ‘passive’ fund or trackers, which aim to replicate the performance of an index, ‘active’ funds employ fund managers to try and select the best performing investments. There are pros and cons for both methods. Passives are cheaper, sometimes substantially so, but they also won’t outperform the index they are following. Meanwhile, finding active fund managers who generate above-average returns over the long term is tricky.
Many active managers have had a particularly tough time keeping up with passives over the past decade. Following the turmoil of the 2007/8 global financial crisis equity markets bounced and then boomed aided by ultra-loose monetary policy. During this time some of the best returns globally have come from the very largest companies.
In the US, for instance, the market has been driven in part by a ‘big six’ comprising Facebook, Apple, Amazon, Microsoft, Google and Johnson & Johnson. Larger companies have also been quick to take advantage of cheap debt, buy back their own stock and increase their earnings per share. These trends have benefited trackers as they invest according to the composition of the index, which is usually weighted according to size.
Active funds, meanwhile, invest according to the manager’s interpretation of merit, not size. They have a tendency to invest less in the very largest companies for reasons of risk management or because they have a preference for smaller firms. Some active fund managers have outperformed but a significant majority have failed to beat their respective indices.
For instance, in the Investment Association Global sector only 27% of active funds have outperformed the MSCI World (the most common benchmark for funds in the sector) over the past decade. For the North America sector the level of outperformance (versus S&P 500) is worse at 15%, while the UK All Companies sector is a bit more creditable at 56% (versus FTSE All Share). Here, small and mid-caps have done better in relative terms and provided a tailwind for some funds.
Following a period where passive strategies have performed well and increased in popularity, a fightback from active funds is long overdue. A reversal of sentiment towards "FANG" stocks (Facebook, Amazon, Netflix and Google), high-flyers with good stories and high growth rates, could tilt the balance back towards active funds, particularly those taking a contrarian or ‘value’ approach that focuses on cheaper, unfashionable shares.
A return of sustained volatility could also assist the relative returns of active managers. In volatile markets the dispersion of stock returns increases, often accompanied by the mispricing of risk which provides a fertile hunting ground. It doesn’t guarantee outperformance, just the range of potential outcomes, and to succeed, managers need to have the skill to turn dispersion into performance. Nonetheless, as monetary policy continues to be normalised globally an increased dispersion of returns could favour the more discerning approach taken by differentiated active funds.
Active managers tend to earn their stripes over market cycles and not necessarily through an extended bull market where valuations get more stretched. While passive funds should be applauded for increasing the focus on cost, which has rightly put pressure on active funds to demonstrate value for money, concentrating on this alone without being conscious of risk versus return balance is unhealthy. There is a place for both active and passive funds in a portfolio, which is why we advocate a ‘best of both’ approach when choosing investments.
This article is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investors should be aware that past performance is not a reliable indicator of future results and that the price of shares and other investments, and the income derived from them, may fall as well as rise and the amount realised may be less than the original sum invested. Investment decisions in collectives should only be made after reading the Key Investor Information Document, Supplemental Information Document and/or Prospectus. If you are unsure of the suitability of your investment please seek professional advice.