Do Active Funds Underperform? But Costs are the Real Problem

On the 24 October the Financial Times FTfm supplement led with a front page article that was headlined “99% of Active US equity funds underperform”. It also had a sub heading of “Almost all UK, global and EM funds have failed to outperform since 2006″. So I sent a letter to the Editor which said the following, much of which they have published today (31/10/2016) plus letters from other writers making the same point. This is what my letter said:

“Your headline in FTfm that 99% of active US equity funds under-perform might make a good lead story, but perhaps you would care to say how many passive funds under-perform their indices. Would it be 100% by any chance? Bearing in mind that all funds have charges, they are almost bound to under-perform their comparable benchmark and that is particularly so for passive funds.

Indices tend to overstate performance as is well known as poor performing stocks drop out of the index, with better performing ones replacing them.

In addition if your readers failed to read to the end of the article, they would have missed the fact that four out of five active equity funds beat their benchmark over the past five years, even after taking into account management and other charges presumably!

Yes there are poor value active funds, as there are poor value passive funds. And perhaps investors are over optimistic in their capability to pick active managers who will outperform their benchmarks. But it is not as simple a story as made out in the article.”

The real problem for investors is the high charges that can erode their returns. This was highlighted recently in a report published by Better Finance. This is what they say:

“The findings from the 2016 research report released on 27 September 2016 clearly confirm that the long-term performance of the actual savings products promoted to EU citizens (in particular for long-term and pension savings) unfortunately has little in common with the performance of capital markets. This Is mainly due to the fact that most EU citizens invest less, and less directly, in capital market products (such as equities, bonds and low-cost ETFs), but into more “packaged” and fee-laden products (such as life insurance contracts and pension products).

One could argue that insurance and pension products would have similar returns to a mixed portfolio of equities and bonds, since those are the main underlying investment components of the “packaged” products in question. But using this logic to compute returns for retail investor portfolios, like the European Securities and Markets Authority (ESMA) did, implies a “leap of faith” in that it completely ignores realities such as fees and commissions charged on retail products, portfolio turnover rates, manager’s risks, etc. Charges alone totally invalidate this approach.

Overall, a direct balanced investment (50% in European equities / 50% in Euro bonds ) from a European saver in capita! markets at the eve of the century would have returned a substantial +105% in nominal terms (gross of fees and taxes) and +47% in real terms, which means an annual average real return of +2.5%. Unfortunately most pension savings did not, on average, return anything close to those of capital markets, and in too many cases even wiped out the real value for European pension savers (i.e. provided a negative return after inflation).”

Their estimate for the net real returns from pension savings in a range of European countries actually shows the UK third out of 17 with a return of 2.5%. But most countries were much worse.

There is of course a simple solution to this problem. Namely to manage your own investments as ShareSoc regularly advocates. With the availability of “self-select” SIPPs this is now easy to do and your costs will then be as low as you can possibly make them.

Roger Lawson

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2 thoughts on “Do Active Funds Underperform? But Costs are the Real Problem

  1. It’s certainly true that charges are important, but ETFs now have very low charges in some cases, e.g. 0.07% for Vanguard and ishares S&P trackers, so the challenge for active fund managers in large liquid markets is real. In the UK you have e.g. the ishares mid-250 tracker at 0.4%, I doubt there are many active fund managers who have beaten it.

  2. The investment management industry needs to experience some Darwinian rationalisation. Yes, it is possible to generate alpha, and yes, some managers do so quite effectively, at least in the short term. But there are a large number of very poor managers out there and in aggregate the industry consistently fails to add value after costs. As Roger points out, a self-managed portfolio can be very cost efficient provided investors have the time, patience and resources to identify and properly research a portfolio of high conviction opportunities.

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