Secrets of Success: Make sure it really is active management
Saturday 05 March 2005
One theme that came out strongly from my recent analysis of Anthony Bolton's career at Fidelity is the importance, if you are proposing to pay for an actively managed fund, of having an investment approach that creates the potential for you to outperform the market by a significant degree. That might sound obvious, but you would be amazed how many funds sold to the public for hefty active management fees turn out not to fall into that category at all.
There are, as has been argued in this space many times, perfectly valid reasons to own both index-tracking funds and actively managed funds: it is not simply an either/or choice. Many investors will sensibly choose to use cheap and efficient index funds to obtain the majority of their exposure to the main markets and asset classes, and then top this up with one or more carefully selected actively managed funds in specific market or sector niches.
This makes sense because there are times when mainstream equity index funds will lag behind a fair number of actively managed funds because of style and other effects. The period since the end of the bull market in 2000 has been a good example, with smaller companies and a value approach outperforming the market by a significant margin. As it can be quite difficult to capture these effects through suitable index funds, a proven actively managed fund with the relevant approach can make sense (though the fast-growing range of sector, style and country exchange-traded funds on offer can also often do the same job just as well for lower fees, and will become increasingly attractive as an alternative).
What you must avoid is the great mass of dysfunctional funds that charge standard active management fees for doing something little different from the market. To illustrate how big a problem this can be, I recently did a simple spreadsheet analysis of the 400 or so mainstream UK equity unit trusts/OEICs in the Fund Expert database.
The metric I used was a simple statistic known to its friends as r-squared. This measures the extent to which the performance of a fund can be "explained" by the movement in the stock market over comparable periods. A fund whose performance can be entirely explained by the movement of the market (as should be the case for the best index funds) will have an r-squared of 1.0. All other funds will have an r-squared of less than 1.0, the precise number being dependent on how divergent the investment approach of the fund is from the market.
Bolton's Special Situations fund has consistently displayed a low r-squared relative to its competitors. Over its 25-year history, the fund's average score on this measure has been around 0.7. This is consistent with Bolton's belief that the only way to outperform the market over time is to do something different from the market, which is reflected in his contrarian value-oriented investment approach.
How does this figure compare with other top-performing funds? To check that, I first screened out the 10 per cent of equity funds with the highest Sharpe ratios over the past three years. The Sharpe ratio is another statistical measure, used in the fund business to measure risk-adjusted returns, by relating the returns of a fund to its volatility. The next step was to look at the range and average of these funds on a variety of measures, including the r-squared figure. The index chosen to represent the market was the FTSE All-Share index. The results are shown in the table.
To qualify for a top 10 per cent ranking, you needed to have a Sharpe ratio of more than 0.3 per cent, quite a high figure for this kind of analysis, reflecting the fact that the past three years have been a relatively good period for active management. (There was a point during the depths of the bear market when less than 10 funds out of 4,000 had a positive Sharpe ratio).
The great majority of funds today (65 per cent) still have Sharpe ratios of less than zero, underlining the well-established fact that most funds do not offer value for money.
But the average r-squared for the top-performing funds was as low as 0.6, with the range running from 0.46 to 0.87. These funds were doing something very different from the market as a whole, though in many cases this was simply because they were operating in the small and midcap sectors of the market, which were themselves less correlated with the All-Share index than normal.
But at least these funds had an opportunity to deliver something that might add value to those who invested in them. About half the 400 UK equity funds, by contrast, had a three-year r-squared of more than 0.9, making it virtually impossible for them to outperform the market by a sufficient margin to produce a positive risk-adjusted return or justify their active management fees. The moral is not that a low r-squared is necessarily a good predictor of future outperformance. Like all backward-looking measures, it only tells you what worked in the past. Doing something different from the market can work both ways: a poor fund manager who deviates from the market by a large margin may well end up losing, for the simple reason that beating the market is difficult.
But if you are going to pick a fund that has a chance of justifying active management fees, it will certainly need to show a low r-squared over the term you choose to hold it.
Funds that have demonstrated that in the past and have an investment philosophy that is consistent and stable should then come into consideration. But the scores of funds that have r-squareds of more than say 0.9 (about half the total) can and should be struck out of consideration, unless they are index funds.
Fuel poverty could kill 100,000 vulnerable people over the next 15 years, charity warns
Phoenix Life: Chance of a refund for overcharged policyholders has risen
Simon Read: You're guilty until proven innocent when HMRC sends in the tax credit detectives
Simon Read: That's right, BT, they'd rather pay for a free service
Bank-beating exchange rates on your international payments
- 1 Forget 'The Dress': Here are five of the biggest news stories you might have missed
- 2 The black and blue dress: Makers considering a white and gold version
- 3 PornHub turns masturbation into energy in bid to save the planet
- 5 Saudi Muslim cleric claims the Earth is 'stationary' and the sun rotates around it
New theory could prove how life began and disprove God
Half of Ukip voters say they are prejudiced against people of other races
This is what it's like to be dead, according to a guy who died for a bit
'Cash for access' scandal: Sir Malcolm Rifkind says 'unrealistic' for MPs to live on £67,000 salary
'Jihadi John': CAGE representative storms off Sky News accusing Kay Burley of Islamophobia
Ukip would cut billions from Scottish budget to fund English tax cuts
iJobs Money & Business
£40000 - £50000 per annum + pro rata: SThree: SThree Group have been well esta...
£30000 - £37000 per annum: Recruitment Genius: Established in 1999, a highly r...
£250-£300 Day Rate: Jemma Gent: Are you a qualified accountant with strong exp...
£230 - £260 Day Rate: Jemma Gent: Do you want to stamp your footprint in histo...
Day In a Page
This six-bedroom Georgian home is on three floors with open fireplaces, a two-oven Aga, an annexe, and cottage gardens with outbuildings and a car barn
High Crest House covers an impressive 9384sq ft, with almost three acres of grounds including a tennis court and summer house enclosed by electric gates
A six-bedroom farmhouse with separate accommodation in converted stables. Situated in the village of Church Aston, within walking distance to the market town
A two-bedroom flat with under-heated walnut floors and bespoke built-in storage. The Tube and Clapham Common are a short stroll away
A refurbished seven-bedroom townhouse with staff quarters, cinema room, superb gym, steam room and plunge pool
A minimnalist four-bedroom home designed to the highest spec, featuring glass walls and a kitchen space lit by a glass roof
Hibernate during winter and make your living during the summer at this busy guesthouse with panoramic sea views, in the village of Lynton
A four-bedroom penthouse next to the Tate with direct views of St Paul's from two floors of luxurious living space
A four-bedroom detached home surrounded by spacious gardens and woodland, close to New Pudsey
An 18th-century, three-bedroom home near Langstone Harbour built from ships beams with vaulted ceilings and wood burning stoves
A five-bedroom semi-detached home with a mix of period and modern features in a popular and convenient location
This five-bedroom red-brick beauty overlooks the village green and sits in just under two acres of land
A three-bedroom villa with self-contained flat, minutes from Lake Windermere
A deceptively spacious, beautifully presented Georgian home with 3000sq ft of living space and five reception rooms
A five-bedroom Victorian home with four receptions, superb gardens and paddock in Pembury
An eight-bedroom house on the south side of the The Green with cinema, wine cellars and summer house
This 17th century beauty is full of rustic cosiness, while the detached home office means you can also run a business
Four exclusive apartments in a Grade II-listed former medical school with 2,275 sq ft of living space and 18ft ceilings
A five-bedroom terraced house on the popular Peterborough Estate, ideally located for both Eel Brook Common and South Park
A state-of-the-art farm-building conversion on the former Cliveden Estate, with 11,420sq ft of internal space, cinema and wine cellar
A three-bedroom, 15th-century cottage with original features in the picturesque village of Sissinghurst
A six-bedroom terraced house with large south-facing roof terrace, cinema room and wine cellar
A new seven-bedroom home built in Queen Anne-style with swimming pool and parkland views in Mortimer
A listed, four-bedroom farmhouse in the rural hamlet of Rushall with detached barn, four acres of gardens and paddocks
A first-floor flat with two bedrooms, a spacious reception room and communal grounds in a leafy part of London
A three-bedroom flat with a spacious rootop terrace and balcony, accessed from a private gated courtyard
A Grade II-listed pile with six bedrooms, stables and 39 acres of grounds in Standlake
A two-bedroom flat with boutique hotel-style interiors, close to the foodie haunt of West End Lane
A two-bedroom flat in a beautiful old vicarage, with many original features, close to the city centre
A three-bedroom 16th-century home with an aga kitchen, private gardens and heated outdoor pool, in Hadleigh
A three-bedrom home in sought-after Queen's Gate Mews, with Italian marble-finished bathrooms
Surrounded by glorious countryside in the village of Udimore, sits this impressive four-kiln oast and barn conversion
A five-bedroom house in the picturesque village of Kettlewell, north Yorkshire
An 18th-century former coaching inn with original staircase, open fireplaces and beams throughout
A Grade II-listed Georgian town house with three bedrooms and a south-facing courtyard, near Arundel Castle
Feel on top of the world at this über chic penthouse on the 37th floor of one of Europe’s tallest blocks.
A Grade II-listed Victorian villa with six bedrooms and two further cottages, all with spectacular sea views
A grade II-listed, Georgian cottage with mature 50ft garden, perfect for summer entertaining
A magnificent Georgian pile with turrets, seven bedrooms, a heated pool and four acres of gardens
Fairoak Farm has five bedroom suites, gym, outdoor swimming pool and golf course
Chic two-bedroom river-fronted flat with a private lift that delivers you directly to your home
A spectacular seven-bedroom Tudor pile, once owned by Henry VIII, with 18 acres of land
A seven-bedroom Georgian property previously used as a picturesque wedding venue
A split-level flat in a church conversion with two en suite bedrooms and 1,200sq ft of living space
A three-bedroom bungalow situated behind an impressive stone wall, £645,000
Windsor Castle overlooks this three-bedroom Victorian cottage located on one of Windsor's smartest roads