Investors are increasingly convinced by the case for passive investment – tracking the performance of the market using a low-cost computer-run fund – versus active management, where a highly paid human fund manager tries to beat the market. As much as 40% of the money in US equity funds is now passively managed, and it’s little wonder. The long-term evidence generally comes down hard on the side of passive being the way to go.
Last year, The Wall Street Journal, using data from Wharton Research Data Services, found that only a fifth of actively managed large-company funds beat the S&P 500 over the previous 25 years. Meanwhile, Ben Johnson of Morningstar suggests that over the past 40 years the Vanguard 500 fund, which tracks the S&P 500, has beaten the average active US large-cap fund by around 0.5% a year after fees. That would have turned $10,000 invested with Vanguard in August 1976 into $652,000 by the start of this year, versus $549,000 for your average active fund.
So is it time to give up on active management completely? We’ve always been big fans of passive investing – but we wouldn’t go quite that far. Not every active manager is a dud – and under some market conditions, active managers have a much better chance of thriving, it seems. A 2014 Vanguard study found that only 29% of US fund managers beat their benchmarks in the decade from 1990-2000. However, this rose to 63% from 1999-2009, and was a reasonable 45% in the decade to the end of 2013.
So what made the difference? It basically boils down to investment styles going in and out of fashion. In the run up to the tech bubble bursting, large-cap “growth” stocks were in favour. So unless a fund manager was betting on the biggest stocks, with relatively high price/earnings ratios, then they would have failed to beat the market.
From 1999, on the other hand, “value” stocks (loosely speaking, those that are cheap relative to the market) and small-caps came back into fashion. Because active managers as a group tend to have a heavier weighting towards smaller stocks than an index, beating the market became easier.
So how can you find a market-beating active fund? If there’s a lesson from this study, it’s that if a fund manager is to be successful, they have to do something different from their peers. So find a manager with a clear, transparent strategy and the stamina to stick with it. Even if their approach is out of fashion, they’ll be well placed to benefit when times change. Secondly, costs still matter: a 2013 Vanguard study found the cheapest active funds have a much better chance (around 40%) of beating the market than the dearest.