This week, I offer one more thought on the subject of actively versus passively managed funds, based on some interesting numbers that have come out in research I am doing for the forthcoming paperback edition of my book about Fidelity's Anthony Bolton. They are pretty fairly summed up in the simple line chart that accompanies this column.
What this shows is the relative performance of the main category of UK equity funds and the FTSE All-Share index, which is treated here as a sensible proxy for the performance of the stock market as a whole.
The data cover the 27 years since 1979; since the advent of the Thatcher government and the years leading up to the start of the great bull market of the 1980s and 1990s.
To read the chart, you need to take a line through the zero mark on the left-hand scale. When the line is above zero, it means that the average fund in the UK All Companies sector has outperformed the All-Share index over the preceding three years.
When it is below zero, it means the average fund has lagged the index on the same measure. Taking a three-year rolling return seems a reasonable timescale for the experiment, though the picture is not much different if you take shorter or longer period returns instead.
And the story it tells is a striking one; a period in the early to mid-1980s when the average fund handsomely outperformed the market; a really bad period of underperformance during the 1990-91 recession and bear market; a slow recovery in the early 1990s; then a long period of underperformance in the second half of the decade; and finally, since 2000, a period of positive but small superior returns from the average equity market fund.
There are, I concede, legitimate questions you can raise about the data. For example, the number of funds represented in the early years covered by the chart is based on a smaller sample than in later years.
There have also been changes in the way the unit trust industry categorises funds since then as well, which may cast some doubt on the reliability of the early-year numbers.
But, logically and intuitively, it should be no surprise that the heyday of actively-managed funds should have been in the early 1980s, the era before Big Bang, when the stock market was nothing like as well researched or competitive as it is now. Good information was hard to come by; insider trading was much more common; and few companies offered steady or reliable information to the market-place.
Stock analysts in general, with some famous exceptions, were amateurs by comparison to today's community. There were no such things as index funds. It was a time when you would expect the smartest, best-informed investors to have a good chance of outdoing the market, which is certainly what most of those in the market believed to be possible at the time.
The years that followed Big Bang saw the UK gradually came into line with what was already happening in the United States, where the stock market had been deregulated a decade or so earlier and was already seeing the fruits of the powerful trends that still characterise markets today - the move towards global markets, huge leaps in the technology of information transfer, and ever more professional market participants.
Beating the market was no longer the cakewalk it once had been for the savvy investor. Throw in the style factors I mentioned a couple of weeks ago - for example, that actively-managed funds tend to invest in smaller companies - and doubts about the value of active fund management were bound to grow into disappointment as the large-stock bull market moved to its climax. In academic jargon, markets have surely become more "efficient" than they were before.
The doubts about active management in mature markets like the UK and US are well founded, as readers know. In fact, I calculate that the average UK equity fund has underperformed the All-Share index in 58 per cent of the 307 rolling 12-month periods since 1979, and in 54 per cent of the 283 three-year periods. Given that the best years were all in the early 1980s, you can readily appreciate how much worse the subsequent period has been.
It is true that the average margin of underperformance isn't great - just 0.4 per cent over rolling one-year periods and 1.3 per cent over three-year periods. But the figures are strikingly worse than they once were: since 1989, for example, the margin of underperformance is about three times greater than over the whole period since 1979. Taking transaction costs into account, investors have not in aggregate had a great deal from the actively managed fund industry.
Still, the trend has been better since the end of the bull market in 2000. Figures from Richard Bernstein, the quantitative analyst at Merrill Lynch, show a similar trend in the US. More than half actively-managed funds there have beaten the S&P 500 index for each of the last five years, the longest-ever run of its kind.
With other style factors, he highlights the fact that market breadth - the number of stocks beating the market each year - has also been above 50 per cent during those years. This increases the odds that the best active stock-pickers can win.
But the most striking fact is that the margin of outperformance remains very small by historical standards. In other words, even in these unusually favourable market conditions, the days when active managers overall could trounce the market are long gone. And looking forward, if the market rotates back into large cap stocks (as I expect), it would be a big surprise if the next five years did not see index funds making a comeback after their disappointments, while active managers (with honourable exceptions) start to struggle again. Bernstein of Merrill thinks the same.Reuse content