Active fund managers underperform passive funds

We have barely brushed off the holiday sand from the beach but already the siren calls from the active fund managers have started.

The message is familiar but tailored for our times, with the current iteration something like: “We live in unchartered times in which bonds and share prices can fall together – that’s why you need an active manager to navigate such treacherous waters. Whatever you do, don’t try to invest on your own when our experienced professionals can generate better returns with lower risk.’’

The only problem with this spiel is that it shows the fund managers actually don’t know as much about the markets they claim to be experts in as they say.

If they did, they would know that in the long term, active management – the type usually offered with high fees from flash city offices with deep carpets – is a serious wealth risk that underperforms simple index exchange traded funds (ETFs).

How do we know this?

Research continues to back passive funds

Research has shown that in the long term, and often in the shorter term for that matter, passive investment that can be achieved with a very low level of financial education outperforms the active investment by the “professionals” most of the time.

One of the most enduring measures of this is the S&P Indices versus Active or SPIVA reports that have been collating data for 20 years in the US market, and for a shorter time in the Australian, and many other markets as well.

The SPIVA reports show how actively managed funds have performed, over both the long and the short term, against appropriate benchmarks.

They do this through two main measures – scorecards that compare active and passive returns and a measure of persistence or consistency which shows whether some active funds are able to consistently outperform their relevant index comparison.

Active funds do poorly on outperformance

They do not make for pretty reading if you are an active fund manager – partly because by charging investment fees active managers start out on the race with one hand tied behind their back, and also because the construction of an index provides a formidable “active” investment machine, buying more shares that are rising and selling down those that are falling.

The active manager might boast they can pick winners and not buy losers, but the way an index does this is very hard to beat.

How hard?

Well, over 15 years, more than 70% of actively managed funds failed to outperform their comparison index covering a wide variety of equity and fixed income funds.

The figures were a little closer over shorter time periods with 55.4% of US active funds underperforming over one year, quickly rising to 85.9% underperforming over three years.

It was a very similar story here in Australia, with 47.9% of general equity active funds underperforming over one year, rising to 82.9% over 15 years.

That is a solid but not absolutely convincing case for choosing passive versus active management.

Active managers lack consistency

However, what if there is a group of active managers that consistently outperforms, and you do enough research to find and invest with them?

Unfortunately, the persistence reports show that this club of consistently outperforming active managers is a lot more exclusive than you might believe, and almost makes the idea of finding a “good” active manager over the long term an impossible quest.

Remarkably, the US Persistence Report put out in the middle of 2022 showed that absolutely no active funds that had performed in the top quartile for the 12 months to June 2020 remained in that quartile for the following two years.

The report also found that using the top 50% of US domestic equity funds in the year to June 2018, there was only a 1% chance of a top half performer still being a top half performer at the end of June 2022.

That is real needle in the haystack territory and makes choosing a consistently top performing active manager an almost impossible task.

Australian active managers do a little better

The picture was a little better for the Australian funds, with the persistence scorecard from June 2022 showing that less than 10% of Australian equity funds in the top quartile in the middle of June 2020 remained there just two years later.

None of the top performing funds in the International Equity, Bond or A-REIT categories remained in the top quartile.

So, what conclusions can we draw from this measure of long-term performance?

Well, active managers can perform well and the figures show in Australia they perform a little better than in the US, but any outperformance by beating the index tends to fall away over time.

The longer you look forward, the higher the chance that any active manager will underperform the index.

Money is flowing towards passive funds

All of which explains a lot about where investor funds went in 2022 – a trend towards passive funds that is likely to continue in 2023.

According to data from ETF provider BetaShares, the five largest fund outflows from last year were all active managers, led by $4 billion of net outflows by troubled fund manager Magellan.

In total, the Australian ETF industry received $13.5 billion of net inflows in a year where the unlisted funds industry had its worst year on record with net outflows of $26.8 billion.