Active Funds Don't Deliver

Most people use actively managed funds to get exposure to the stock market. This is the traditional way to get the higher returns that equities can offer for long term investors without the work and risk involved in selecting individual shares. This return is a mixture of total return of the index plus an additional amount, known as the excess return, which a fund manager can achieve by avoiding shares he thinks expensive and buying more of the ones he thinks are cheap. His, or her, basis for selecting shares comes from research and perhaps from meeting the company and hearing first hand what it is doing and what its prospects are. However, this is time consuming and is not always that productive in a world where inside information is illegal.

Tracking the performance of active fund managers is a full time job and Trustnet, Bestinvest and Citywire are the best places for an amateur without access to professional services, such as Lipper and Morningstar to get an objective opinion of how good a fund manager is.

Is the manager earning enough return for the risk he is taking?

Some fund managers simply buy companies they think are cheap based on the evidence available in the balance sheet on its cash flow, its debt or its forecast earnings. Doing this is time consuming and hard work and most active managers hold far less than the all the shares in the market. That means they are taking more risk than just that of the asset class. The amount of risk the fund is taking can be measured by the tracking error. A good fund can be identified because it will have a positive excess returns and a beta of more than one no matter what its tracking error is. That means it is taking more risks than the market and is getting a better return. As tracking error goes up so should the excess return. Dividing the excess return, by the tracking error, the extra risk, gives us the information ratio. That tells us if the fund is getting enough extra reward to compensate for the extra risks it is taking. You can find these data on the Trustnet website.

How accurate are labels?

You might think that a fund labeled as a UK fund would only hold shares in UK listed companies. In fact that is not the case. Under the Investment Managers Association rules that determine which category a fund is placed in it is possible for a fund to hold up to 20% of its portfolio in foreign stocks. That is not a problem as long as investors know that some of the return from such as fund will come from asset allocation and not stock selection. In other words the fund may benefit, or suffer, from the beta of a foreign stock exchange. Clearly, such a fund will have a different risk profile to one that is confined to UK stocks only. It is also worth noting that some funds are able to use derivative, such as options or futures to enhance returns. That may or may not reduce risk or increase returns but it does introduce another aspect for investors to consider.

How consistent is the manager?

Unfortunately, history shows that some managers are good in some conditions, like a rising market, and others are good in different conditions, perhaps one that is falling for a while. And there is no one to tell you if we are in rising or falling markets. In the same way no one will tell you when is the right time to buy or sell technology or commodity shares. What is important is to be invested in the market to catch the good days. Timing the market does not work.

Choosing a manager is much harder than choosing a share and there is a whole sub-industry dedicated to it. Considering that 66% of managers underperform their benchmark, i.e. have negative alpha, in any three year period the job is quite important. Even if they do match or beat the index then it is important to consider how much risk, measured by the tracking error, it has incurred to achieve that return. If a fund took more risk than it received in performance it will have a negative information ratio. Few active funds have consistently positive information ratios.

Does it do what it says on the tin?

One feature that is common to most active fund managers is that they tend to have strong views on most things. These views can be on such things as oil prices, interest rates, currencies and where the market is going. Now, the reason we invest in equities is that research, such as that from the Barclays Equity Gilt study, demonstrates that over the long-term the market goes up. So any fund manager who takes a negative view on the stock market in the short-term by holding more cash than normal is taking an additional risk. Is that something you expect him to do or do you assume that all the money you invest in the fund will be placed into the market? If he is not fully invested, and the market rises, the investor will lose out. In fact the key to stock market success is time in the market and not trying to time the market as this data from Fidelity demonstrates.

How loyal is the manager?

But there is another problem. Fund managers are not, on the whole, terribly loyal and half of them change jobs every five years. According to the UK Fund Industry Review and Directory 2005 only 43% of fund managers have run their fund for 4 years or more. So even if you find a good one the chances that he or she will be there after two decades is less than 6%. Keeping an eye on all these managers is an important part of the selection process.

Why fund managers focus on beating each other rather the market

Finally, we need to consider the black art of performance measurement. How much is skill, how much is luck and what are we really measuring. Consider this. In any one year 50% of the funds should beat the market. Even after including costs 42% will be ahead of the average. The next year 18% of that group will be ahead based on simple averages, then 7.4% in the next and 3.1% after that. So by year five 1.3% could still be ahead based purely on luck. To put that into perspective it means that 4 funds out of the 324 in the IMA UK All companies sector could owe their market beating returns to pure chance. In fact over the five years to end November 2008 57 actually beat the market. But which four got there by luck? However, the industry tends to focus on returns relative to their peers rather than to the index and are usually categorised by quartile performance ratings. Over that period 141 funds, or 54% of them, beat the average and made it into the first or second quartile. The difference between the 141 that beat the average return and the 57, or 22% of the total, which actually beat the market is the reason why most active fund performance data focuses on beating their peers rather than the market. The obsession with quartile rankings neatly diverts attention away from whether the fund actually did its job of delivering additional return on top of the market return.

What are you paying for?

Annual management fees on active funds are typically over 1% and can be as much as 1.75%. That higher price relative to passive funds is supposed to cover the cost of the research that active fund managers carry out on their investments. But these days interviewing company executives is less productive than it used to be because listed companies are obliged to divulge all price sensitive information to everyone at the same time. That is why there are so many company announcements, at least four for each plc every year, and some of these statements can be 100 pages long. How can one fund manager, and his analysts, genuinely read and interpret all that data, let alone have time to meet executives for anodyne conversations. Given that 78% of them failed to even beat the market it can easily be argued that active funds over promise and under deliver. They advertise alpha and most fail even to provide beta. It is the additional cost of active management that results in this group actually delivering lower returns than passive funds as this US study proves.

Invest in the wood, not individual trees

The reality of investing is that the majority of the investment return comes from the asset allocation strategy and not from picking individual stocks. That was determined in a landmark study by Brinson and others. Although the precise numbers have been debated few experts quibble with the view that asset allocation is more important that stock selection.

An example of how difficult stock selection is provided by an analysis of the technology sector. According to this report just 5% of 1,705 tech stocks listed over the last 22 years provided 100% of the returns. Stock pickers can easily get bogged down in the detail of a company at the expense of ensuring he gets the full return of the market.

Picking stocks can be fun and it can also be rewarding. Nevertheless, ultimately it is a loser's game that does not benefit the investor. While there are exceptions, on the whole, picking stocks is an expensive and unrewarding pastime. Modern investment theory has moved on to ensure that attention is focussed on the wood, not the individual trees in it.

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