Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Todd Schlanger, Vanguard’s investment strategist, investigates why and how active funds outperform passive ones.
Recent data suggests that UK active equity managers have turned a corner, following years when the majority of active funds underperformed their benchmarks. Indeed, according to data from Morningstar over the three-year period ending December 31 2015, more than half of UK active equity funds outperformed the FTSE All-Share Index.
So Why the Outperformance?
Some have argued that the recent bear market in equities has helped active funds to outperform. There is a common perception that actively managed equity funds will outperform their benchmark in a bear market because, in theory, active managers can move into cash or rotate into defensive securities. In reality, the probability that these managers will move fund assets to defensive stocks or cash at just the right time is low. Most events that result in major changes in market direction are unanticipated.
Having said that, the case for indexing tends to be strongest in the long-run. Over shorter periods, the percentage of active funds underperforming will vary. Much of this is due to the cyclical nature of the financial markets and the fact that different styles of investing come in and out of favour at different times. For example, to take a typical benchmark, the FTSE All-Share Index. Although it consists of large-, mid- and small-cap stocks, the largest 10 companies make up around 30% of its market capitalisation. Active funds, however, will tend to favour the higher growth prospects of small-cap.
Given this bias, when small-cap outperforms large-cap, it’s likely that a greater proportion of active equity funds will outperform. Let’s look at the data. The chart below plots the percentage of active UK equity funds underperforming the FTSE All-Share over rolling three-year periods dating back to 1990. On the opposite axis, we plot the rolling three-year performance of the FTSE 100 Index, representing UK large-cap equities, relative to the FTSE Small-Cap Index, representing UK small-cap.
The correlation between these two lines is high, at +0.88, indicating that the success of UK active equity funds is highly influenced by the relative performance of small versus large-cap equities.
This is important for investors to keep in mind when evaluating the performance of active equity managers, who are charging fees, either to select outperforming stocks or to time entry and exit from market segments. The chart clearly shows that, although there are periods where active equity managers have outperformed on average, periods of outperformance have tended to be cyclical and coincide with the outperformance of small-cap equities.
What Does This Mean For Me?
When evaluating active equity fund managers, investors need to ask two questions. Is the manager following a market-driven style bias, such as value, momentum, or small-cap equities? And, are they able to switch from one style-bias to another as the market cycle turns? If the answer is yes to the former and no to the latter, then investors might want to consider whether they wouldn’t be better off in a low-cost, rules-based factor fund.
If the other way around, the active manager is probably doing what they are paid for, selecting outperforming stocks and timing entry and exit from market segments.
Disclaimer
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