It depends on how irritable I am feeling on any given day, but sometimes, when I am listening to a fund manager warbling on about the way in which his special investing method has brought his fund fame and fortune, I lean forward – just a little, in a friendly sort of a way – and say: “How do you know you aren’t just very lucky?”
This is mostly taken as an invitation to explain to me a little bit more about just how price-to-growth or free cash flow ratios are the key to success. And that makes me dream of the day when a manager shrugs, smiles and says: “I don’t”.
I have long suspected – as regular readers will know – that good performance is more often than not a function of luck. We know that the average fund underperforms the index all of the time. And all the statistics show us that very few funds manage to stay at the top of the league tables for more than a couple of years.
Buy a top-performing fund now, and you can be pretty sure that it will be an underperforming fund at some point in the next three years.
That’s why increasing numbers of investors only buy tracker funds or exchange-traded funds (ETFs). These also, by definition, underperform the market – they track an index, but thanks to their operational costs, will always do a little worse than that index. But they are also cheap – and that matters. If it costs 0.2-0.3% a year to hold an ETF, and 1.0-1.5% plus to hold a unit trust, why – given that both on average always mildly underperform – would you hold the actively managed fund over the passive?
The clear answer is that you wouldn’t. Both will underperform, but the cheaper fund will underperform less – which, of course, is why the ETF industry is growing so fast. You might think this argument is now all but settled. But I’m not as sure as I was. Instead, I am beginning to wonder if investor sentiment is swinging a little too far in favour of passive investments.
The key thought here – and one that Angus Tulloch at First State has been pointing out to me for some years now – is that, while the average fund might underperform, that doesn’t mean the average fund investor will underperform. Good investors have the sense to buy good investment funds – those with clear and reasonable philosophies and processes alongside stable management and reasonable long-term performance.
Sceptical? Me too. But I now have a bit of research to back up Angus’s convictions. It comes from Simon Evan-Cook at Guildford-based asset management company Premier. Evan-Cook points out that the usual calculation of average performance gives all existing funds the same weighting. This makes no sense, given that “most fund sectors are dominated by a few behemoths” into which ordinary investors are heavily invested.
Take the equity income sector, for example. At the beginning of 2012, there were 92 funds in it. But Neil Woodford, via just three Invesco Perpetual funds, was responsible for running 40% of all the money invested in it; his funds together were bigger than 84 of the remaining 89 funds combined. Yet if you simply added up the performance of the funds and divided by 92, as any conventional analysis would, his funds would account for only 3.3% of the sector performance.
The point is that if you want to see if the average investor (rather than the average fund) is beating the market, you need to calculate a weighted average of fund performance. This is, after all, how most stock indices are run – they are weighted by market capitalisation.
Redefine average like this, says Evan-Cook, and you find that, over the past five years, “in almost all cases the average investor is doing better than the average fund”. How about that?
This isn’t definitive proof of anything, but it does suggest that choosing a good fund isn’t as hopeless a task as you might think. I’m encouraged in this thought by a few other things.
The financial crisis has highlighted the difference between sensible and stupid investment pretty clearly, and some good research has been done on the difference between the two – in particular, Andrew Lapthorne at Société Générale makes an excellent (and well back-tested) case for long-term stock selection based on quality and value.
There has also been a key shift in the market that makes it much easier to give active managers the benefit of the doubt. It is price.
I have a copy of an article written in The Statist in 1965, complaining that new funds charged an initial fee of “3.5 to 5% and thereafter, an annual service charge ranging from 0.5 to 0.375 of a per cent.” Until very recently, that remained the case.
Today, however, the fund management industry – encouraged by regulatory change – is beginning to get it. In the investment trust sector, many of the best trusts already charge less than 0.7% a year and scale their charges down as they grow. Unit trust charges are heading in much the same direction.
That changes the active versus passive maths. If you think you can find a fund that focuses on total returns; that has managers capable of sticking to one of the few methods of investing that history tells us work over the long term; and is going to cost you only a little more than a tracker fund – why wouldn’t you favour it over that tracker fund?
• This article was first published in the Financial Times.