Active fund managers are doing it tough at the moment but I for one are barracking for them to make a lower cost comeback.
That might sound strange coming from someone who is an avowed fan of passive investment using very low-cost exchange traded funds (ETFs) to get broad diversification.
I do think it is hard for active fund managers to outperform those index ETFs after fees but it is by no means impossible – particularly if active fund managers can bring down their fees.
It is no secret that some of the big active fund managers have been struggling of late, including Perpetual (ASX: PPT), its takeover target Pendal (ASX: PDL), AMP (ASX: AMP), Platinum Asset Management (ASX: PTM), Magellan Financial Group (ASX: MFG) and Janus Henderson (ASX: JHG) to name but a few.
Young investors embrace ETFs
Falling share prices and slumping funds under management are the flip side of the acceleration of cheap and effective ETFs that have been embraced, particularly by younger investors.
The Morningstar figures lay out the picture clearly, with passively managed funds getting positive net fund inflows of $84.2 billion since the start of 2017 at the same time as active funds suffered net outflows of $9.1 billion.
Over 20 years since the early days of passive funds in Australia, they have seen inflows of $122 billion while active funds have only gained $3 billion of inflows.
It is not hard to find the reason for the growing popularity of ETFs – they usually charge around 0.25% in management fees – sometimes much less – while active funds usually charge about 1% to manage your money and sometimes a lot more.
Low fees and great performance is hard to beat
Active fund managers might have been able to survive charging higher fees if they had achieved better investment performance but unfortunately the reverse is true – in average terms index ETFs have outperformed the majority of active managers after fees.
There are some active managers that outperform but it is rarely the same manager year in and year out.
For example, one year the value managers who buy strong companies that are trading fairly cheaply might have a good year but then the next year, it might be the growth at reasonable price managers that top the tables or quantitative traders.
Picking an active manager that can consistently outperform, say, the ASX 200 index, is very difficult because the combination of high fees and the changing investment picture make consistent outperformance very difficult.
The active fund managers are effectively starting with one hand tied behind their backs.
Nevertheless, I remain a fan of active managers for a few reasons: the main one ironically being that the success of passive ETFs should help them to make better decisions.
There are some cheaper active managers
Two examples of active fund managers I use are Australian Investment Company (ASX: AFI) and Argo (ASX: ARG) – both old school listed investment companies.
While some investors look down their noses at these long established LICs, I like them because they bring a lot of grey-haired investment experience to the table and they also charge more reasonable investment fees – AFI’s fees, for example, were just 0.16% for the 2021-22 year.
Don’t get me wrong, these active managers are not excitement junkies that are going to shoot out the lights by buying crypto at the bottom.
Their style is more like making a judgement call to lighten off their holdings in one of the big four banks because they are not convinced by management’s plans or they think the shares are too expensive.
However, they keep their ears to the ground, they actually interview a lot of executives and board members and they are astute managers with plenty of cash in the kitty when they see an opportunity.
Unsurprisingly, they tend to have a very consistent investment performance and over time they tend to outperform the ASX 200 accumulation index, although obviously some years are better than others.
Using the core and satellite approach, with passive index ETFs at the centre and active investments orbiting around, these LICs are well worth considering for some conservative active management that pays out strong franked dividends and doesn’t work up big tax bills by massive trading churn.
Active managers can add value for small companies and offshore
While the LICs are one possibility for an active alternative to the ASX 200, the two other opportunities where I think active managers can really earn their fees are in analysing smaller companies and in investing in offshore markets.
Interestingly one of the giant passive funds on the ASX, Vanguard Australian Shares (ASX: VAS) recently outperformed the ASX 200 for an interesting reason.
While it is still a passive fund, it invests in the top 300 companies on the ASX and those extra 100 smaller companies helped it to add a bit of extra return and beat the index.
That shows the potential of smaller companies, which in general can grow faster and outperform larger companies, even if they have a higher chance of being undercapitalised and failing.
This is where I think active managers can really earn their fees, ploughing through the financial reports of thousands of small companies – both listed and unlisted – and assembling some potential growth superstars that could really shoot out the lights on performance.
Similarly, while it is also prudent to use very low-cost ETFs to cover major overseas indices such as the S&P 500, it is also a good idea to use a couple of promising and hopefully low cost active fund managers as international satellites to hopefully add some extra returns.
Active funds can outsmart ‘dumb’ ETFs
There is another area where I think active managers can add a lot of value but to do so they are going to need to find a model in which they can charge lower fees.
ETFs are “dumb” funds in that they are simply choosing which shares to buy and sell based on the size of the company as measured on the share market.
They are actually actively managed to a limited extent because shrinking companies that fall out of the ASX 200 index, for instance, are actively sold as they shrink and then disposed of altogether as they fall out of the index.
Similarly, rising companies are progressively bought as they grow bigger, compounding or pyramiding returns for the ETF.
Bigger not always better
This is both the biggest strength of index ETFs and their biggest weakness – they hug the index very accurately but their sole reason to choose companies is size as measured by market capitalisation.
It is here that active managers should be able to beat the “dumb” funds by intensively researching the rising stars and overloading on the very best of them and similarly by selling out earlier from some of the falling companies.
Active managers are also free to hold lower numbers of companies, hopefully avoiding some of the duds and selecting some of the companies with more growth potential.
Actively managed funds are certainly feeling the heat at the moment but with growing chunks of money flowing into passive strategies, the best and most nimble of them should have even greater opportunities to outperform.
