Challenging the passive versus active fund wisdom
Research into high-actives shows more volatility and sharper corrections than average
A DECADE ago, a mere 19 per cent of the open-ended funds domiciled in the UK invested passively. Today, according to Morningstar, that number is nearly 30 per cent and rising. On its face, this makes complete sense.
Passive funds are cheaper than active – and when you buy active, you rarely get what you pay for. In the first half of 2024, only 31 per cent of UK-focused active equity funds beat the average passive fund in their sector. Over the last five years, that number is still only 36 per cent.
No wonder, say analysts at the AJ Bell investment platform in their latest Manager vs. Machine report, so much money is pouring out of active funds – £89 billion (S$153 billion) since the start of 2022 in the UK; and that makes active managers start “to feel like an endangered species”.
But think a bit harder, and it’s hard to make sense of it. Fund managers are among the most educated and intelligent people on the planet. Think top grades, brilliant jobs, super high salaries, proud parents; so how, you might ask, can it possibly be that year in, year out, a spreadsheet effectively outperforms these obvious successes?
The short answer might be that it isn’t true. A recent paper from Steven Holden at Copley Fund Research makes the point that the word active can cover a range of strategies – some fairly indistinguishable from passive strategies and some wildly different. So, if you want to figure out the truth about performance, you need to divide them into the genuinely active, the sort of active, and the not very active at all.
The simplest method is to look at their “active share” – the percentage of their portfolios that is different from the indexes they are judged against. If that is below 60 per cent, the funds can be considered low active; 60 to 75 per cent is medium active, 75 per cent-plus is high active.
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Look at only the last, the genuinely active, and the picture, in the UK at least, changes completely. High-active funds have outperformed their lower-active share peers (after fees), says Holden. “They have also outperformed a passive ETF tracking the FTSE All Share. Since April 2012, high-active share funds have returned 164 per cent on average, compared to 131.6 per cent for low-active share, 126.2 per cent for medium-active share, and 134.5 per cent for the benchmark FTSE All Share ETF.”
There are a few caveats to all this. The outperformance from high active doesn’t come every year – 2022 was a very nasty period for high active, something that still weighs on their three-year performance. It is also worth remembering that hidden within the averages will be some massive outperformers and a few total nightmares; other research into high-active funds shows more volatility and sharper corrections than the average fund.
The research might also not carry over to other markets. It is famously harder to outperform in the super-concentrated and well-covered US market than in the much-neglected UK market. AJ Bell numbers suggest that over the last 10 years, 42 per cent of all UK funds that call themselves active have outperformed. In the US, only 22 per cent have managed the same.
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Finally, being low active – or almost passive – isn’t necessarily a problem. Twenty years ago, a large number of funds called themselves active and charged active-style fees but were actually closet trackers. That was dishonest.
Lots of today’s low-active funds are designed to be that way – they are “enhanced index” or “beta plus”, specifically aiming not to stray too far from the index. I’m not sure why you’d want that over a plain-old passive fund, but it isn’t dishonest. We can consider that an improvement of sorts.
Active-share numbers don’t give all the answers. Far from it. But Holden’s research should give hope to the industry – all those qualifications were not for nothing. It should also give hope to investors trying to choose investments. You might keep being told there is no hope of long-term outperformance with active funds. But start by choosing one run by a manager who cares more for making you absolute returns than hugging a benchmark, and there is. BLOOMBERG
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