Fear or greed?
22 December 2017 | Portfolio construction
Commentary by Ankul Daga, Vanguard senior investment strategist.
In Renaissance Italy, merchants financed trading vessels crewed by skilled navigators and seamen in an attempt to profit through trade with merchants in other lands. Some vessels produced fortunes for their backers, others led to bankruptcy.
While these outcomes could be more dramatic than modern active fund management, we can still draw parallels. Investors back managers to navigate the financial markets and seek profit from trade with other managers. This pursuit of outperformance can make for an entertaining spectacle. On the first day of every month the captain-managers, supported by a talented crew of sailor-analysts, experienced in the risky shoals and winds of the ocean-market, set sail in search of opportunities to trade and barter. And at the end of the month comes journey's end, the factsheet marking out with cruel certainty the profit and loss of the venture.
So, what about the investor?
In Renaissance Italy, the success of the investors depended not only on the profitability of the captain's trades, but on the cost of furnishing and equipping the ship, and providing for the crew. The same is true in modern times for those holding shares or units in investment funds. We thought it would be interesting to look at actively managed equity funds available to UK investors from that same perspective and to evaluate their performance before and after costs.
Our research showed that before costs active equity funds show definite promise. A majority outperformed their prospective benchmarks over all the holding periods we examined (Figure 1). Even better, over longer time periods the proportion of outperforming managers increased. Over 10 years it reached 68%, a fairly high number.
Unfortunately, that was the extent of the good news. Looking at the same funds over the same periods, net of fees1, and the opposite picture emerged. Only a minority outperformed, again across every period, and the proportion of those outperforming increased over longer periods. The evidence is clear. Active equity fund managers are certainly capable of adding value, but they often charge more than their investment performance earns.
Figure 1: Percentage of investor assets outperforming and underperforming
Note: Active equity funds available to UK investors. Source: Morningstar, Vanguard calculations based on Morningstar data, fees are asset-weighted. Statistics are for rolling periods from January 2003 to April 2017. Past performance is not a reliable indicator of future results.
Is it greed or fear?
Typically we found fees on active equity funds to be around 150 basis points. This puts active managers under constant pressure to cover their management fees and more. The higher the fees, the higher the hurdle. These high hurdles can sometimes force managers to take risks which might have otherwise been unnecessary. This is the fear factor.
All else being equal, a lower cost active fund manager can focus on his or her team's competitive advantage without flirting with positions beyond their core area of expertise. Whereas their higher cost competitors are likely to be constantly occupied with outperforming beyond their hurdle.
In line with convention, higher cost would suggest better performance. In fact, it's the opposite. You get what you don't pay for. A closer look at active managers across the cost spectrum reveals that lower-cost active funds tend to outperform much more than their higher cost peers.
What's the alternative?
For many investors, passive funds can be a good solution. Even though passives don't offer the potential to beat the benchmark, in aggregate, they tend to deliver a better return for most investors after costs.
In contrast, active managers (in aggregate) skilfully beat their benchmark before taxing fund returns with costs and charges. The end result, in my view, is that sometimes greed overwhelms talent!
The table below shows the performance of active and passive equity funds available to UK investors over different time horizons. Rather than focus only on recent experience, we computed rolling performance over various holding periods starting in January 2003 and going all the way to April 2017.
Figure 2: Annualised asset weighted return (%) received by UK equity investors
Note: Active equity funds available to UK investors. Source: Morningstar, Vanguard calculations based on Morningstar data, fees are asset-weighted. Statistics are for rolling periods from January 2003 to April 2017.
At the end of the day, it's not about whether the captain, or the fund manager, are able consistently to complete trades that are successful in themselves. They need to be profitable after costs. In fund management, the client's success depends wholly on whether or not their portfolio meets their goals after costs.
Whether the client picks an active fund or not should depend on whether it is likely to help them meet their goals. We believe advisers and many investors would be better served by selecting high-quality, low-cost funds which meet investor needs. For some investors it might be a low-cost active fund and for others it might be a diversified passive fund. The higher the cost of an active fund, the less likely it is to deliver value to the end investor.
1 "Net of fees" means net of fees such as management, administration, marketing and distribution fees, which are included in the expense ratio of the fund and deducted from fund assets. Net of fees does not mean net of sales charges (such as front-end loads, deferred loads and redemption fees).
This article is directed at professional investors and should not be distributed to, or relied upon by, retail investors.
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.
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