The active versus passive debate has raged on for more than a decade now as costs of trackers continue to fall.
While much of the debate is merely a matter of opinion, the increased focus on fees it has created has put pressure on active managers – especially after 2016 turned out to be a dreadful one for them.
It was a major topic of discussion earlier this week as Dow Jones released its annual review of active management, with the research highlighting that nine out of 10 UK equity managers failed to beat their benchmarks last year.
Within parts of the trade press, the coverage of this report was typically sensationalist – with some journalists questioning whether stock pickers add value at all despite the fact it was just a 12-month period – and an extraordinary one at that, as we will discuss shortly.
Coincidentally, we have been putting together our own analysis on active managers over recent weeks and here we will highlight our findings and show that, while there are certainly merits in using passive strategies, writing off active funds at this stage would be a mistake.
2016: A year to forget
While the Dow Jones study looks at all active managers in the UK, we only focused on the open and closed-ended funds in the respective Investment Association and Association of Investment Companies’ UK All Companies, UK Equity Income and UK Smaller Companies – but our results were broadly similar.
Throughout this research we have compared the performance of open and closed-ended funds in the UK All Companies and UK Equity Income sectors against the FTSE All Share and the portfolios in the UK Smaller Companies peer groups against the Numis Smaller Companies Ex IT index. Yes, not all funds are necessarily benchmarked against those indices, but they are nonetheless indices investors in UK equity funds would hope their active manager could beat over the longer term.
According to our research, just 12.9% of UK equity investment trusts managed to beat their respective indices in 2016. The figure is only slightly better in the open-ended sphere, where just 15.3% outperformed last year.
That doesn’t make for great reading for fans of active strategies but before you switch sides it is worth noting that, while 2016 was dire, 2015 was the complete opposite. Indeed, among closed and open-ended UK funds, 80.7% and 81.4%respectively beat their indices that year.
What’s more, the reason for this huge swing in relative performance comes down to sector positioning rather than poor stockpicking. For example, the large majority of active managers were underweight two of the FTSE’s largest sectors (mining and energy) in 2015, instead preferring domestically-orientated mid and small-caps, which ended up benefitting from improvements in the UK economy and the surprise Tory majority at the general election.
According to our research, active managers were – on average – 46% underweight basic materials relative to the index over the course of 2015 and 60.7% underweight energy. This turned out to be a very successful call, as those two sectors were pummelled by China’s slowing growth and falling commodity prices with the FTSE All Share Basic Materials index losing 40% and the FTSE All Share Oil & Gas index losing 20%.
Source: Morningstar
In 2016, however, these heavily bombed out areas witnessed significant return to form with basic materials returning 90% and oil and gas stocks up 60%. This is highlighted in the graph above, which illustrates the performance of the two indices relative to the FTSE All Share (so underperformance versus the index – not absolute return – is shown when the lines fall and outperformance is shown when the lines rise). Of course, active managers could be criticised for this, but our research shows that positioning within the open and closed-ended UK sectors stayed the same with managers maintaining their underweight positions two mining and oil over the course of 2016.
Clearly, therefore, most active managers didn’t and still don’t believe this rally is the start of a long bull-run for mining and oil.
Source: Morningstar
On the other hand, it may come as little surprise the five best performing open-ended UK funds in 2016 (when their average return was 35.8%) were all bottom-quartile in their respective sectors in 2015 and failed to beat the FTSE All Share (when their average loss was 5.8%). Not coincidentally, these five funds were significantly overweight basic materials relative to their peers and the index over the course of the two tears years, which is highlighted in the graph below.
Source: Morningstar/FE Analytics
This isn’t an excuse for UK active managers’ poor performance, of course, but it does highlight how extreme the market rotation in 2016 was (especially when those two industries make up more than 20% of the FTSE All Share and therefore it is very difficult to be overweight those sectors). In fact, when you look over the longer term, our research shows just how much of a freak year 2016 was.
In fact, the worst year this century…
2016 was in fact the worst year for active managers this century (by that we mean since 2000, so just 17 years, but it still makes a good sound bite…). The chart below illustrates this dynamic nicely.
Before that, the worst year had been 2007 when 26.1% of UK investment trusts and 29.2% of UK open-ended funds failed to beat their relevant indices. However, on a far more positive note, our research shows that – taken on average – active managers in the UK have added value.
Source: Morningstar
Indeed, over those 17 years on average, 51.8% of active open-ended UK funds have outperformed. The figure is even higher in the closed-ended space as 56.6% of UK investment trusts have beaten their respective indices in NAV total return terms over those 17 years on average, once again highlighting the benefits of the closed-ended structure including the ability to gear and the fact it is a fixed pool of capital. In fact, in 12 of the past 17 years, more than half of UK investment trusts have beaten their respective indices. In the open-ended sectors, the figure is lower as more than half of funds have outperformed in 10 of the past 17 years.
It is worth bearing in mind that all the figures in this report are net of fees.
The cumulative effect
The major point about active management is that funds will go through periods of under and outperformance throughout the cycle depending on whether or not their investment style is in favour. The aim, of course, is to find managers whose periods of outperformance outweigh the periods of underperformance.
When looking at cumulative returns, our research shows active managers in the investment trust sectors have generally added value relative to their respective indices (less so in the open-ended space). As the table below also shows, closed-ended funds have also largely beaten their equivalent open-ended peers over longer time frames as well.
Source: Morningstar, to 31/12/2016
However, when taken on average, it is somewhat of a mixed bag. As such, when you start looking at the ‘average’ return, it is no wonder may investors start wanting a low-cost tracker. Which brings us on to our next point…
Survivorship bias
Many active vs passives studies have been put together in the past, but one major factor that can push the results in favour of active managers is survivorship bias, when figures become skewed because the observer is only considering funds that are still in existence today and excluding those that have since been shut down (usually on the back of poor performance).
Our figures don’t have survivorship bias as we have included every IA UK fund and AIC UK trust that has existed since 2000 – including those which aren’t in business any more. Nevertheless, we can show just how much of a difference survivorship bias can make to the results and why many investors are wary of going down the active route when it comes to asset allocation given the risk they could end up backing a dog that gets shut down due to consistent underperformance.
The table below shows the cumulative performance of IA UK sectors against the relevant indices over those 17 years. As you can see, by simply excluding those funds that have since been shut or merged, the performance of active managers has been significantly better. Without survivorship bias, however, the ‘average’ IA UK All Companies and IA UK Smaller Companies funds have underperformed.
Source: Morningstar, to 31/12/2016
In fact, as part of our research, we estimate that more than 160 IA UK funds have been closed or merged between 2008 and 2016 with the total number of funds (so including those that have been removed as well as those that have since been launched) having fallen by 18% from 447 in 2008 to 366 in 2016.
We estimate that 17 UK closed-ended funds have been closed since 2008. The number of trusts in existence has fallen at a similar level as in the open-ended space (in percentage terms), with the total number peaking at 64 in 2008 and has since fallen to 53 representing a 17% decline. The chart below shows just how many active open-ended funds failed to survive in the aftermath of the global financial crisis of 2008.
Source: Morningstar
Despite this, survivorship bias has had the opposite effect in the UK trust space. The more thorough analysis – including funds which are now closed – actually shows better performance figures. As the table shows, performance figures where survivorship bias is taken into account are significantly higher than those where it is ignored (except in the AIC UK Smaller Companies sector).
Source: Morningstar, to 31/12/2016
What this shows, therefore, is that many of the UK trusts that have been launched since 2000 have gone on to outperform and suggests that many trusts that have since been liquidated delivered decent NAV returns.
Conclusion
It’s clear that 2016 was a very bad year for active managers. However, our research shows that 2016 was also somewhat of a freak (and was created by the stark outperformance of active funds in 2015) and shouldn’t be used as a reason to write off active managers in the UK.
However, as we noted at the start, the debate over whether active or passive offers the best equity exposure for investors will never end and we are conscious that any research into active versus passives will always boil down to averages – the problem there being that the ‘average’ active fund does not exist.
Investors either take out manager risk and accept the index’s return by buying a tracker (although those returns are always likely to be lower due to charges) or, after due diligence, choose an active fund and risk underperforming the index in the hope their active manager can significantly outperform.
Given the amount of poor performing portfolios that have been closed and resigned to the history books, there will always be investors who will always believe outperformance revolves around luck and want to go down the passive route due to past experiences. At the same time, however, history proves that certain active managers can add genuine value – and our research shows that a higher proportion of those are investment trusts.
With this in mind, next week we will highlight and analyse the best and most consistent closed-ended UK funds since the millennium.
