The UK fund management industry has a couple of shameful secrets. The first is the way it charges. I’ve written about this many times before so I won’t bore you at length on the matter. I just want to send you in the direction of a new study from Cass Business School, which points out two things.
First is that the worst type of fee structure from the point of view of investors is one in which the manager is paid either a flat percentage of the assets under management, or a flat percentage plus a performance fee.
Second is that the best is a symmetric fee, one in which both manager and investor share in the upside and the downside of the fund’s performance.
One is almost always used in the UK. The other never is. I don’t think you need me to tell you which is which. The study, for those in any doubt, is called “Heads We Win, Tails You Lose”.
On to the second shame: the huge number of index tracker funds in the UK masquerading as actively managed funds (“closet trackers”). This one might be worse. The fees business is exploitative, irritating and backward. The closet tracker business is all those things but with a hint of fraud chucked in. Why are they so awful? Simple. These are funds that are sold to you as being actively managed by some clever guy in the City and come with the kind of fees such clever guys think they deserve (the average ongoing charge is 1.43%).
However, they aren’t actually particularly actively managed. Instead, their managers, hamstrung by their industry’s terror of underperforming the index (what if people take their money out and they lose their job?) just buy and hold more or less the same stocks as are tracked by whatever their benchmark index is, and hope for the best. The result? Mediocre performance before fees are subtracted, and utterly awful performance after they are taken out.
You’ll be wondering how you know if you have one of these fakes in your portfolio. The first clue will be in the rubbish returns you will have been making. But other than that you can run your eye down the main holdings in the fund and compare them to the benchmark (the more that match, the worse it is) or you can look at a measure referred to as Active Share.
This was developed by Yale professors Martijn Cremers and Antti Petajisto in 2007, but basically measures just how different to the index any given portfolio is.
If your fund has an Active Share (AS) of under 60 (that is, 60% of the fund’s holdings mirror the index) it is not an active fund. It is a tracker or a closet tracker.
In the UK £58bn of investors money supposedly being actively managed is held inside funds with an AS of under 60. That’s some 29% of the total in UK equity funds. If you have one of them you are being ripped off. Sell it now.
But once you start to think about how many trackers there are in the UK that are classified as active by the industry another problem comes to light. Their existence skews the entire debate about the performance of the average active fund versus the average passive fund in the UK. Why? Because closet trackers (and their appalling performance) are classed as active funds. So when you compare the “average passive fund” to the “average active fund” you are actually comparing the passive sector to a combined group of lots of very expensive closet trackers and a smaller number of genuinely active funds. No wonder pure passive usually wins the numbers war.
This brings me to some work recently done by Simon Evan-Cook at Premier Fund Management. He has had a go at stripping the fakes out and then calculating separately the performance history of highly active funds (with an AS of 80 or more), active funds (60-80), closet trackers (15-60) and genuine trackers (0-15).
The results are fascinating. Over the past ten years, the highly actives have returned an average of 10.3% a year (for those who aren’t familiar with stock market return averages I would like to point out that this is amazing). The actives have returned 5.9% and low-cost trackers have returned 4.9%. The index has given you 4.8%. And closet trackers? You guessed it: 4.6%. Only the funds classified as high-cost trackers did worse.
Do the numbers this way and active management beats passive management hands down. Mr Evan-Cook isn’t the only one to come up with these results. The original Yale report found something almost identical. Its conclusion: “Funds with the highest Active Share significantly outperformed their benchmarks”, both before and after expenses, and they “exhibited strong performance persistence”. Other studies have shown that small or “best ideas” portfolios run by managers with real conviction have a tendency to outperform other funds too.
So what does this tell us? The first part of that answer is not everything. There’s what we call “survivor bias” in the numbers. Fund managers whose convictions have turned out to be completely wrong will have been shut down: failure isn’t properly recorded. Then there is the fact that you should never judge investments on one measure alone. A fund with, say, only three stocks in it would have a very high active share. But it would also be running whopping levels of risk. You wouldn’t want it in your pension.
These caveats aside, I think it tells us that we should start agitating for AS to be included on the fact sheet of all the funds on the market so that we can see whether our manager is a person of conviction or not. If we are paying for active we must make sure we get active! This is something that the fund platforms might like to have a go at providing – all those analysts at Hargreaves Lansdown should be able to knock out the AS numbers for the funds on their site in a couple of days.
It also tells us that if we are going to buy passive funds we must buy cheap and transparent passive funds. Obvious but important. And finally it tells us that the statistical battle between active and passive managers is not yet won: if you are looking for long-term outperformance (and who isn’t?) there is, after all, a very good case to be made for buying funds with very high AS, a good record and a reasonable price. Next week: a list of candidates (suggestions, as ever, very welcome).