Active fund managers use their skill and experience to pick which stocks to invest in. An alternative to active investing is to invest in low-cost index funds. One criticism of index funds is that they blindly invest in a broad index which might not always make sense. Index funds participate in the highs and lows. This led me to consider how well actively managed funds did last year.
Last year’s share market opportunities
Between 1 January 2020 and mid-March, the international share index (MSCI World ex-Australia hedged to AUD) fell by approximately 20%. By the end of the 2020 calendar year, the international share index bounced back by around 40% (between mid-March and Dec 2020) to finish the full calendar year up by around 11%.
The Australian market didn’t fare as well, but its volatility was still high. The Australian share index (ASX300) fell by approximately 27% to mid-March and then bounced back by almost 33% between mid-March and the end of 2020 calendar year. It finished the 2020 calendar year in a minor loss position (down about 3%).
But this is only part of the story. The market’s reaction to Covid created some obvious long term investing opportunities for active investors as some sectors were punished a lot more than others. These include oil and gas, airlines, travel and tourism, real estate and banking.
Active fund managers and investors should outperform in a bear market
In a bull market, almost all stocks are rising so investing in a broad index should capture most of these returns. Logic would have us believe that a bear market probably creates opportunities for active investors. For example, at the heights of covid lockdowns last year, technology stocks were the best performers. But as the vaccines immerged, the sectors that were more severely punished began to recover strongly. As such, and admittedly, with the benefit of hindsight, an active manager could have been overweight tech for half of 2020 and then switched to the recovering sectors for the remaining half of the year. This approach would have outperformed the index.
Certainly, we are all wiser in hindsight, and perhaps it’s a little bit unfair to undertake this analysis. However, the point I am attempting to make is that if you pay an active manager higher fees, isn’t it reasonable to expect that they will outperform in such a volatile market?
How did active managers do last year?
US based index firm, S&P Dow Jones Indices prepares the Standard Poor’s Index Versus Active (SPIVA) report every 6 months. It compares the investment performance generated by all active managers to the index, to calculate the proportion of active managers that failed to beat their relevant index. The table below summaries the results for the 2020 calendar year.
Apart from Europe, more than half of active fund managers failed to beat the index in a year that presented a lot of opportunity to do so.
Longer term performance however is more compelling. Generally, over any 5 year period, approximately 75% to 80% of active fund managers fail to beat the index. And of the 20% to 25% of active managers that do beat the index, it’s not the same managers each year. In fact, data shows that less than 10% of outperforming managers can outperform for more than 2 years in a row. Outperformance is usually short-lived.
A lot of active fund managers are index huggers
Many active managers are scared to under-perform the index, because it’s not good for their business (less people want to invest with them). As such, they tend to construct their portfolios to closely replicate the index, to minimise the risk of under-performing it. This is called index hugging. But why would you want to pay an active manager between two and ten times more in investment fees just to replicate an index? Of course, you wouldn’t (and you shouldn’t!).
Similarly, actively managed funds rarely go to cash because if they are not fully invested in the market when it takes off, they will miss all the returns. But perhaps, if you are paying high fees for an active manager, maybe you want them to reduce their investment exposure in some markets.
A recap on the benefits of active versus rules-based investing
Rules-based investing includes traditional index funds and factor-based investing. It differs from actively managed funds in that they don’t pay portfolio managers a lot of money to make subjective decisions. Instead, they use rules-based, quantitative methodologies. There are four main advantages to this:
- Better investment returns – as noted above, index funds tend to outperform the vast majority of actively managed funds. And it eliminates the ‘risk’ of picking which active manager to use.
- Lower fees – active managers tend to charge fees in the range of 1.0% to 1.5% p.a. However, index fund fees tend to be in the range of 0.2% and 0.4% p.a. – some are as low as 0.04% p.a.
- Lower tax – index funds tend to be more tax-efficient because their turnover of stocks is lower (less buying and selling) and therefore less realised gains. Maximising your capital growth in return for minimising income means you pay less tax each year.
- Very diversified – index funds tend to be very diversified and the level of diversification (or lack of concentration risk) is the common thread in methodologies that tend to produce better returns. For example, Vanguard’s international index fund holds over 1,500 individual stocks. Almost all active funds hold less than 100, often fewer.
If the ‘experts’ can’t do it, what chance do you have?
There is a huge body of evidence that demonstrates that adopting a rules-based approach when investing in the share market is likely to generate better returns net of fees and taxes. That is not to say that it will beat every active manager, every year. Of course, there are always exceptions to every rule. But if you want the highest probability of generating good returns (and therefore accept lower investment risk), rules-based investing is the way to go.
In addition, what 2020 has proved (yet again) is that if you invest in share markets, you must be prepared for volatility. Typically, there’s a big volatility event every decade and smaller events every two to three years. The best thing to do when this happens is to close your eyes (and ears) and focus on long term outcomes. If you can’t do that, then maybe share market investing isn’t suited to you.