I paid for a Ferrari but got a Reliant Robin
If you're a UK investor and you invest an active funds you've got a real problem at the moment. S&P has just published their report recording how well active funds do versus their benchmark and the results are abysmal! That makes me half and half angry and also at the same time sad.
I'm angry because when you pay extra for active funds you should get returns above the benchmark: that's the point, right?
At the same time I'm sad because fund managers are really doing their best. They're not charlatans they're very intelligent people who are trying to beat the index but failing.
If you want to see why I'm riled let's think about value.
If I pay £200,000 for a car it will buy me a Ferrari. But I wouldn't expect to pay 200,000 for a Reliant Robin even if I was an enthusiast.
How does that relate to funds? If I buy an active fund there's a human in charge of buying and selling assets and that's relatively expensive. If I'm paying a fee I want to be repaid more than the fee in terms of outperformance measured relative to a benchmark. If I don't get that outperformance, well, I may as well just buy the benchmark. I'll go for a passive fund which costs less and all it has to do is match an index like the FTSE 100 or the S&P 500 stock index in the US.
Standard & Poor's is a company which maintains indices. For over a decade they've been keeping track of active funds in the US and elsewhere to see one of those active funds have outperformed the benchmark. So here's the U.S. Ninety-two percent of the funds and remember, these are equity funds, underperformed the S&P 500 and that's over a five year period. The data below looks at actively managed European equity funds and it measures performance over a 1-, 3-, 5- and 10-year investment horizon. Here's the table which upset me.
Now look at the one year column: that measures performance versus the benchmark over the last year and here's UK equity. Eighty seven point two percent of the funds were outperformed by the benchmark. Over a ten-year period three quarters of them were outperformed by their benchmark and that also applies to large-cap mid-cap and small-cap equities, which means big companies medium companies and small companies.
That means that as a UK investor at the beginning of 2016 there was a ninety percent chance that you'd have chosen a fund which would underperform its benchmark in 2016 and that wasn't just a blip. If you go back over a period of ten years and in 2006 you chose a fund there's a 75 percent chance that fund would have underperformed the index over that ten-year period. And that is what makes me sad
The job of an active equity fund manager is to choose stocks which outperform the market. That's what they're paid for. But the evidence looks fairly overwhelming that they can't beat the market. Well if you can't beat the market you could just buy the market cheaply.
A typical active fund will charge you 0.75% of your investment every year as a fee. In contrast, a passive fund will cost you three to ten times less because just tracking an index is very cheap, there's very little skill involved. And that's what we mean when we say "Buy the Market".
In the U.S. Vanguard is the real champion of cheap passive funds. For example some of their funds just charge point zero seven percent fee per year and those very low fees have forced every fund to reduce their charges and the message about underperformance and cheap passive funds has definitely got through to investors. In this graph from the FT you can see that the cash has been pouring into passive funds while at the same time it's been pouring out of active funds and that's been happening for almost a decade.
Does the underperformance of your funds frustrate you? We'd love to know - tell us!
This is not a recommendation. If you want advice tailored to your circumstances seek independent financial advice.
So if you're not happy with your active fund performance and you don't think the managers are worth their fee then the solution is simple: don't get angry, don't get sad. Remember you can just move your money from active to passive management.
- Death of the Alpha Cult: https://pensioncraft.com/death-alpha-cult/
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