Why the markets outperform the professionals' managed funds most years

For a moment - just one brief, tantalising moment - it looked as there was going to be a large shock in the investment stakes this year. When the WM Company, which monitors fund managers' performance, took its first pass at analysing how well pension funds had done with their investments in 1996, it found what looked like startling evidence.

It seemed that those funds which were "actively managed" had come out on top again in the performance stakes.

The early returns suggested that while the FT All-share index last year produced a total return of 16.8 per cent, the average actively managed pension fund had achieved a return of 17.2 per cent, a small but significant advantage.

If confirmed, it would have meant that professional fund managers collectively had beaten the main stock market index for only the third time in the last 10 years.

But alas, for the industry's self-esteem, the first cut proved to be a false signal. A month on, there has been time to collect and analyse the performance data further, and now the figures have had to be revised. WM, which monitors results from 80 per cent of the pension funds in this country, now calculates that the outcome last year was a dead heat. The pension funds in its survey produced a return of 16.8 per cent - exactly the same as the index itself had produced.

In historical terms, this was still quite an achievement. For ever since professional fund managers started to analyse their performance in detail (which was not all that long ago), the message has almost invariably been the same. In any one year, the majority of professional fund managers are incapable of beating the main stock market indices.

And if that were not bad enough, the chances of any fund manager beating the index repeatedly over a period of years are much slimmer still.

The evidence on this point, as I have had cause to mention here before, is quite incontrovertible. Every study that has been carried out into fund management performance, whether it is in the United States or here, and whether it is pension funds, unit trusts, investment trusts or whatever, arrives at roughly the same conclusion. This is that around 80 per cent of professionally managed funds will underperform the market as a whole each year.

WM's own data shows that 1992 was the only year in the last 10 when pension funds actually made a return greater than that of the index (though in 1994, they did manage to produce a smaller negative return than the index).

If you look at studies of individual fund management performance over time, the evidence is similarly clear-cut. Fund managers who appear in the top 25 per cent of performers in any five or 10-year period are more likely than not to be in the bottom half in the succeeding five or 10- year period, In fact, there is some evidence to support the view that picking the worst performing fund management group is just as likely to produce above average performance in the future.

Credit for the first discovery of this painful truth about the fund management business is probably owed to a distinguished American philanthropist, Alfred Cowles, who demonstrated as long ago as 1933 that the returns achieved by insurance companies were no better or no worse than those which would have been generated by a randomly selected portfolio of stocks. But it has taken the advent of modern computers to demonstrate conclusively quite how persistent and relentless this phenomenon is.

When you think about it, of course, this finding is really not as surprising as it may seem. Fund managers collectively are the market, so it is inevitable that collectively they should be unable to beat the market index. The main reason they persistently fail even to match it, however, lies in the cost of their doing business - their management fees on the one hand and all the money they put into the pockets of stockbrokers when they buy and sell the shares in their portfolio.

While the average fund manager cannot beat the stock market, many individual fund managers can - and do. In the pension fund field, the top quartile of performers typically produce a return that is between 2 per cent and 6 per cent greater than the market as a whole.

Something similar happens in the unit trust and investment trust industry, although most cases of outperformance are due more to the particular sector or country that the trust has chosen to invest in, rather than the stock selection skills of the manager in question.

What is odd is that it has taken so long for investors to arrive at the obvious conclusion - that it may not be worth trying to beat the stock market index any more. Naturally, everybody wants to see their fund in the top half of the performance tables - pension fund trustees are just as dogmatic about that as the average investor.

But is it sensible to set that as a target? As there is now a practical alternative, in the shape of index-tracking funds, whose sole raison d'etre is to mimic the returns on the index, without any pretensions to beating the market averages, the question needs careful consideration.

Not for nothing do WM now estimate that between 20 per cent and 25 per cent of pension fund money is now "passively" managed - ie invested in index-tracking funds. In the United States, the figure is more like 40 per cent. It is the inevitable consequence of taking a long, hard look at the facts of past performance.

Now that ordinary investors have a chance to put their money into an index-tracking fund too - there are already nearly a dozen such funds in this country - the question to ask is not whether you should think about them as an investor, but why you should even think of opting for anything else.

Start your day with The Independent, sign up for daily news emails
Have you tried new the Independent Digital Edition apps?
Finacial products from our partners
Property search
Put the phone down on the coldcallers who see pension liberation as an opportunity to liberate your pension from you

Pension freedoms: How to deal with cold calls from scammers

Sean O'Grady offers advice on keeping your money safe
Switching to a better bank account is much easier than it used to be

More people are switching current accounts – but what do the figures mean?

Experts disagree about the 7% increase over the past year

The chance of getting what appears to be free money can be hugely attractive, especially to first-time buyers who can be fooled into thinking it’s extra cash to buy the essential new items they need for their dream home.

Beware the boom in cashback mortgage deals

Too many mortgages are being sold with misleading gimmicks

The firm’s revenues slumped by a third to £217 million in a disastrous 2014

Wonga results could get even worse this year, chief admits

The firm’s revenues slumped by a third to £217 million in 2014

The cost of a buildings policy has dropped by 10.1 per cent over the year, with the cost of a contents policy falling by 8.2 per cent

Simon Read: Mild winter cuts the cost of home insurance

The average quote for a buildings and contents policy has fallen by 3.6 per cent

Don't count your retirement money yet: employers will stop receiving a pension rebate next year and their staff may lose out

Defined-benefit pension schemes: Rebate change in 2016 may leave you out of pocket

Employees in defined-benefit schemes are held up as the lucky ones, but the state pension scheme will be overhauled in April 2016
Labour will raise the national minimum wage to more than £8 an hour by October 2019 (EPA)

Barclays new Blue Rewards hands cash to customers. What’s the catch?

Joining Barclays Blue Rewards costs £3 a month but then lets customers in for handouts of up to £15 a month

New research reveals that despite the recovering economy, four out of five low-income households have seen no sign of their financial situation improving

Hard-up families could be eligible for financial help

A charity is urging anyone struggling financially to see if they could get help from the state

When is the best time to buy foreign currency?

Video: With an election looming, a hung parliament could hit sterling

General Election 2015: Vote for the party that will boost your finances

Experts warn that the general election is unlikely to lead to stable markets. Simon Read talks to two investment managers who are advising caution

Make the most of your money in 2015-16: The end of the tax year is the beginning of the next...

The new tax year brings with it a raft of new rules and regulations

General Election 2015: Will pension reform be a major factor?

Video: Tom McPhail, head of pensions at Hargreaves Lansdown, says May's outcome could alter your pension

General election 2015: David Cameron's promise brings uncertainty to investors

Video: Simon Read talks to Fidelity's Tom Stevenson

  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Recruitment Genius: Financial Adviser

    £20000 - £60000 per annum: Recruitment Genius: Are you recently QCA Level 4 qu...

    SThree: Graduate Recruitment Resourcer

    £20000 - £22500 per annum + OTE £30K: SThree: SThree Group have been well esta...

    Guru Careers: Application Support Analyst / 1st Line Support

    £25 - 30k: Guru Careers: We are seeking an Application Support Analyst / 1st L...

    Guru Careers: .NET Developer / Web Developer

    £45K - £55K (DOE) + Benefits: Guru Careers: We are seeking a full stack .NET D...

    Day In a Page

    Not even the 'putrid throat' could stop the Ross Poldark swoon-fest'

    Not even the 'putrid throat' could stop the Ross Poldark swoon-fest'

    How a costume drama became a Sunday night staple
    Miliband promises no stamp duty for first-time buyers as he pushes Tories on housing

    Miliband promises no stamp duty for first-time buyers

    Labour leader pushes Tories on housing
    Aviation history is littered with grand failures - from the the Bristol Brabazon to Concorde - but what went wrong with the SuperJumbo?

    Aviation history is littered with grand failures

    But what went wrong with the SuperJumbo?
    Fear of Putin, Islamists and immigration is giving rise to a new generation of Soviet-style 'iron curtains' right across Europe

    Fortress Europe?

    Fear of Putin, Islamists and immigration is giving rise to a new generation of 'iron curtains'
    Never mind what you're wearing, it's what you're reclining on

    Never mind what you're wearing

    It's what you're reclining on that matters
    General Election 2015: Chuka Umunna on the benefits of immigration, humility – and his leader Ed Miliband

    Chuka Umunna: A virus of racism runs through Ukip

    The shadow business secretary on the benefits of immigration, humility – and his leader Ed Miliband
    Yemen crisis: This exotic war will soon become Europe's problem

    Yemen's exotic war will soon affect Europe

    Terrorism and boatloads of desperate migrants will be the outcome of the Saudi air campaign, says Patrick Cockburn
    Marginal Streets project aims to document voters in the run-up to the General Election

    Marginal Streets project documents voters

    Independent photographers Joseph Fox and Orlando Gili are uploading two portraits of constituents to their website for each day of the campaign
    Game of Thrones: Visit the real-life kingdom of Westeros to see where violent history ends and telly tourism begins

    The real-life kingdom of Westeros

    Is there something a little uncomfortable about Game of Thrones shooting in Northern Ireland?
    How to survive a social-media mauling, by the tough women of Twitter

    How to survive a Twitter mauling

    Mary Beard, Caroline Criado-Perez, Louise Mensch, Bunny La Roche and Courtney Barrasford reveal how to trounce the trolls
    Gallipoli centenary: At dawn, the young remember the young who perished in one of the First World War's bloodiest battles

    At dawn, the young remember the young

    A century ago, soldiers of the Empire – many no more than boys – spilt on to Gallipoli’s beaches. On this 100th Anzac Day, there are personal, poetic tributes to their sacrifice
    Dissent is slowly building against the billions spent on presidential campaigns – even among politicians themselves

    Follow the money as never before

    Dissent is slowly building against the billions spent on presidential campaigns – even among politicians themselves, reports Rupert Cornwell
    Samuel West interview: The actor and director on austerity, unionisation, and not mentioning his famous parents

    Samuel West interview

    The actor and director on austerity, unionisation, and not mentioning his famous parents
    General Election 2015: Imagine if the leading political parties were fashion labels

    Imagine if the leading political parties were fashion labels

    Fashion editor, Alexander Fury, on what the leaders' appearances tell us about them
    Phumzile Mlambo-Ngcuka: Home can be the unsafest place for women

    Phumzile Mlambo-Ngcuka: Home can be the unsafest place for women

    The architect of the HeForShe movement and head of UN Women on the world's failure to combat domestic violence