Fund manager actively trades but rarely beats the market. Instead of hiring a stock picker for your portfolio, you should invest in market indexes. The above advice is becoming stronger in today’s times, especially because those indexes have made huge profits in a bull market. The US stock market is entering its ninth year now. Recently released data stresses this idea even more strongly.
Fund Manager Underperformance, How?
Over 6 out of 10 actively managed stocks underperformed their market standards in 2016. This data is as per the S&P Indices vs. Active Funds Scorecard. Large-capital funds were unable to match the S&P 500 66% during that time. Small- and mid-cap funds also failed to outguess their benchmarks 85.5% and 89.3%.
Index funds deliver the market ROI via a broadly diversified portfolio. The risk level is also not more than market level. Hence, to use actively managed funds, they should either give less risk and more returns. This is what the investment world recognizes as a victory of hope over experience.
During 1960s-70s, most active funds were able to deliver high returns. Customers loved them. And, with the increase in fees, fund managers flourished. If all conditions were same today, active funds would still be successful.
But scenarios have altered. New firms came up and proliferated. Established businesses re-structured and then flourished too. Darwin’s evolution threw incompetent fund managers out of the market. Strong companies became stronger and stronger. Competition rose during 1980s-90s.
Resultantly, there was a rise in skills needed to get even moderate success. Today active funds cannot beat the market. The market is outperforming them. Plus, the long-run scenario for active management is unattractive.
Modern data on active managers’ performance was earlier distorted. But, authorities are
now correcting it. They’re doing it by adding back the results of funds into the record.
These funds did so poorly that firms merged them with other funds or closed. They were then removed from the records. The rectified data holds essential messages for investors.
Actively deficient 3 points are essential. In last ten years, 83% of American active funds were unable to match their benchmarks. 40% trip so severely that they’re ended before maturity. 64% funds deviate from their actual style of investing. Such disappointing records are unacceptable in any other industry. These are American statistics. As global firms lead all stock markets, they’re all going on the same path.
Why Active Fund Manager Can’t Beat the Market?
The change drivers causing such poor results are solid and too many. In the last half-century, NYSE saw an increase of 500 times in the trading volume. That is, from 3 million shares per day to 1.5 billion. There is also a considerable rise in investment research. The leading securities companies have nearly 300 analysts of different types. This includes:
- Company analyst
- Market analyst
- Industry analyst
- FOREX and commodities expert
- Political analyst
These analysts are working in all major cities of the world. The number of chartered accountants is up from 0 to 135,000. Another 200,000 are studying for their tests.
Quick communication of information is also helping investors a lot. The different channels ensure that investors have equal and instant access all information. SEC Regulation FD requires that all investors should get equal access to any investment data. Hence any data available to one investor should be published for all investors. This removes what was
earlier the “secret ingredient” of active fund managers: calling “the first shot.”
There are now more than 1m professionals doing price discovery. This number just exploded in last 50 years from an approximate 5000. Hedge funds, have spread immensely and now implement almost 50% of all selling and buying. These funds are the most price-sensitive and intensive market participants. Computer models, algorithms and Artificial
Intelligence (AI) are some of the driving forces.
Hence, institutional investors have a global information network now. This network produces the most efficient and largest prediction market of the world.
Active fund managers can only outperform if they identify and exploit pricing mistakes of other experts. Everyone has the same information at the same time. Plus, these experts have more or less the same drive and talent. The challenge of maintaining a competitive edge at price discovery is fast growing.
The most substantial force driving change is still unnoticed. In the USA, institutional trading is increasing steadily. It went up over the same 50 years from a 9% market share to 20%, 50%, 80% and now 95%. As most retail trading is information-free “noise,” 95% underplays the absolute professionalism of stock market.
Trading volumes may have gone up in a straight line. But, the challenge of attaining greater performance when selling/buying only to/from rivals is increasing. All these competitors are active participants in the same giant information network. The challenge of outguessing the expert pricing consent is speeding up.
This is like the Doppler effect of a fast approaching train’s whistle. The impact of professional trading just with other professionals is making it difficult to outguess the market. All professionals are equally informed and armed and collectively lead the market.
Apparently, some active investors with extraordinary skills will still beat others. But they’ll not compete directly with the various conventionally active fund managers. It also won’t be easy to identify future “winners” in advance.
Percentage of Global Funds Underperform Their Benchmarks in 10-Year Period:
- Global S&P -79.2%
- International S&P -84.1%
- International Small Cap S&P -58.1%
- Emerging markets S&P -89.7%
Source: S&P Dow Jones Indices. Data periods ending December 31, 2015
It can be easier to identify future “winners” in advance in either of the following two cases.
- If a bear market in lag-cap stocks develops
- If price fluctuation or a bull market in small firm stocks develop
If either of the above happens, then we can start hearing stories claiming that “active is
back.” There would be important interviews featuring new heroes of the industry. But,
much of this would be because of high focus on lucky winners. The market would ignore
equally unlucky losers in the broad dispersion of results.
The evidence is on a rise that big changes are nearing. These changes can confuse more and more active fund managers. But, most active investors fail to recognize this truth. As Winston Churchill said once: “We should see the facts because facts are staring at us.”
Hence, the proofs need proper analysis. Only then can we separate long-run secular trends from small-term fluctuations around the temporal patterns. Plus, both of these from the irrelevant, random statistical “noise.”
Screening the profound from the likely – and these two from the transient – could be challenging. This is because smart sellers will find and stock semi-possible, highly-selective evidence. You must have seen this before. E.g., the way Big Tobacco is doubtful about the proof that smoking results in cancer. Or the oil industry doubted climate change.
The Good Old Days
Active investors enjoyed that peaceful day in the 1960s. During this time, they didn’t do more than 20% of the trading in the US. They were always competing on price discovery with non-professionals. These amateurs sold or bought for purposes external to the market.
They wanted to invest an inheritance or bonus, to raise money for buying a home or paying for education. With no research or skills, these amateurs averaged only 1 or 2 trades a year.
At that time, most institutional managers were traditional MFs or trust units of banks. They followed the rules of personal trust investment. That is, holding blue-chip dividend stocks for long-term to evade taxes. Their intention was not to challenge competition. Back then, it wasn’t uncommon for active investors to surpass the market by 200-300 base points. No investor would mind paying 100 points to receive 2-3 times higher returns.
Then, during the 1980s and 1990s, the rate of interest fell from 12% to 4%. This was because of the Fed, which broke inflation expectations by driving interest rates to new levels, let it normalize. Bond and stock prices started an upward surge. They gave investors an annual return of 10%, 12%, and 14%. Which investor would not pay 100 points to get such superb returns?
But today, if bond returns over next some years average 2-3%, will investors pay 100 points?
Or if the stock returns average to 6-7%, will they pay 100 points as fees? This is when most active fund managers are underperforming their selected benchmarks. Index funds predictably yield market-matching returns. Their risk element is also not more than the market. And they don’t charge more than 10 points. Will investors pay 90-120 points more
to get active fund management? Will they take more risk with active management which gives lower ROI?
Before getting the answers, look at the four stages in the last 50 years of active investment:
- Stage 1 (1960-1980): Active investors compete against amateurs and traditional MFs and trust banks. Result: 200-300 points of high performance. No attention toward index funds.
- Stage 2 (1980-2000): Active investors drive a strong bull market. This satisfies clients immensely. But can receive only so much incremental performance to cover their fees and costs. Index funds receive little attention.
- Stage 3 (2000-2010): Active investors are unable to cover all their fees and costs. Index funds are increasing in demand and interest. Moving from active investment to indexing rises from a low base level.
- Stage 4 (2010-2017): Growing number of active investors underperform a professional market. This includes significant firms investing in large caps. The returns average of 7%. Rational observers settle that costs and fees can’t be considered as
“inconsequential.” Demand for index funds increases steadily.
Active managers and their clients were happy with one another during first two phases.
Even in stage 3, memoirs of good times mixed with hopes for returning the previous positive experiences. They didn’t have any explanation on how to attain it. The focus was on yearly or quarterly performance. In this arrangement, short-term fluctuations obscure long-term trends. Investors patiently waited to get better returns.
But Phase 4 was different. Clients learned that the primary concern is not to find a firm of hard-working, skilled managers. Apparently, they can see such an investment firm any day. But this isn’t the correct approach. The question is, “can we find more creative, skilled and harder working active managers?” Sadly, the answer to this question is no.
The fee is conventionally defined as “just 1%” of assets. But in reality, for a 7% return market, they’re 15% of returns. Take incremental fee as a percent of gradual return.
Both against indexing. You’ll realize the incremental fee for active investing is now more than 100%. Such a price-to-value ratio is rarely seen.
Not all active investors will face this shocking truth simultaneously or equally. Managers least exposed to risk are those giving the ideal results. Or the ones who have the perfect client relations. Even the ones with the least demanding clients. Also, managers with unique skills in math or more extended research periods will not be under much pressure.
The highest pressure will be on prominent, conservative active investors of portfolios. These portfolios are dominated by big stocks. Such stocks are carefully priced and owned by professional consensus. The ‘vice of destiny’ will take in layer-after-layer of active investors.
There were many products which commanded a price and produced high margins in a competitive market. But, they were unable to maintain their high profitability. So far, active management has been a success – for active managers. But, the success of the business still attracts more competition, technology, and information. As a result, it’s harder to get superior returns. And, in a low ROI market, this issue is becoming visible to increasing number of clients.
Contrary evidence is building up. Plus, forces driving active manager’s poor performance continue to be understood. Hence, growing number of customers will know that in neck-to-neck rivalry vs. near-equal rivalry, most active investors can’t cover their fee and cost.
Indexing is earning higher returns with less risk and at low cost. And, there is less uncertainty as well. Thus, the world of active investment will fall, company by company. It will no longer hold its once leading position. This painful process is the inevitable outcome of the visible impact of forces of change. As TS Eliot quoted in 1925, “This is how
the world ends. With a whimper, not with a bang.”
The Power of Passive
Passive funds are top-rated among portfolio managers. They’re starting to catch the attention of UK managers as well, claims Aime Williams.
These funds offer low-cost exposure to the market as they track an index. Passive funds have grown four times quicker than their actively managed counterparts since 2007.
As per Morningstar, the best-selling and biggest fund for UK investors is the iShares SP500.
This retail fund collected £60bn of cash. Vanguard’s S&P500 tracker was a close second with £14bn. Net of fees, the funds yielded 42% in a 1-year period and 20% during a 3-year period. This is the returns of S&500 index in both scenarios.
Fund supermarket Hargreaves Lansdown holds almost £60bn of assets of UK retail investors.
The company says 1 out of 10 investors has at least one passive fund in the portfolio. This is an increase from 6% in 2011.
BlackRock’s Consensus 85 is the most popular fund choices for DIY investors. This is a fund of 10 other passive funds holding many Japanese, US and UK equity trackers. It also includes passive bond funds.
US low-cost fund company Vanguard introduced a similar product in 2011. The Vanguard LifeStrategy range. Vanguard declared on Wednesday that it is cutting the fee on strategy from .24% to .22%. The group decided to do so because the fund touched the £5bn mark.
Vanguard will also launch its online supermarket soon. This will give investors an opportunity to remove brokerage.
Laith Khalaf is an investment analyst at Hargreaves. He says due to the fee cut, Vanguard’s fund belongs to the same price range as BlackRock’s strategy.
Other famous passive funds are FTSE trackers that follow the FTSE 100. Besides this, mid-to-small-cap 250 and All Share are also favorite picks.
Apart from passive funds, investors can also access exchange-traded funds. These are index trackers traded on stock exchange.
Robo-advisors suggest portfolios of low-cost ETFs to investors. They’ve also become popular in past few years.
Recognizing the appeal of the system, many high-street banks have declared plans to introduce their robo-advisors. These banks include RBS, UBS, Lloyds, Barclays. Their robo-advisors will provide retail investors more access to passive funds.