Over the last 10 years we have seen the growing popularity of index funds. They now make up c. 14% of the market; up from c. 6% in 2007. We can of course debate what is driving this popularity, and many investors have opinions on this, but let’s leave that for another day.
On my travels up and down the country in the UK and Ireland, many investors have voiced fears that recent index fund outperformance of actively managed funds is a function of upward trending markets and that if we see a correction or downturn in markets, active managers will come to the fore by boosting cash levels or allocating more to defensive stocks. Indeed, we have even heard many fund groups say this.
Whilst it cannot be disputed that actively managed funds have the flexibility to outperform the index on the downside, has this actually happened in practice?
In this rather simple analysis, we start by taking a look back to the Investment Association’s (IA) UK All Companies sector and the bursting of the dotcom bubble and then reviewed how the average manager performed versus a main comparative index, the FTSE All Share.
Over time, the average UK equity manager in this sector has actually outperformed. It is worth noting the IA sectors include smattering of index funds too but are seen as barometers for active managers. Many argue this is due to a mid-cap bias as discussed in my previous blog Sterling Status of UK equity funds, but again let’s leave the debate on those meddling kids for another day.
The results are inconclusive. When the market was down, the average UK equity manager was still able to outperform for investors in one out of the three drawdowns above.
But what about when we look at different equity markets at that period? Let’s focus on two mainstream markets here: one that is often typically referred to as being efficient, namely the US equity market, and one that is inefficient, emerging market equities.
The US market is seen as a poster child for index investing; thought to be one of the most efficient markets available to investors and therefore one of the hardest to beat. As we have only had two discrete year drawdowns since 2013, there is little contest here between the performance of active funds and the S&P 500. In every single instance of a negative return from the average manager in the IA North America sector, the index has outperformed the median fund manager, often by a clear margin as shown in the global financial crisis and after the dotcom Bubble.
Finally, emerging markets equities – an asset class where it is often claimed that actively managed funds should be able to add value. In contrast to the US, this is often referred to as an inefficient market, one which provides plenty of opportunities for nimble active managers with an informational advantage or the ability to identify mispriced stocks. This should provide opportunity for an accomplished active fund manager to outperform.
With this in mind, the chart below shows the average manager in the IA Global EM sector underperforming a falling index across each period, which may be surprising to many.
Mystery solved! When it comes to the myth that actively managed funds often deliver superior performance on the downside, it’s a bit more nuanced than people might claim. Whilst as a group active investors can’t claim to be more defensive than the market, it is worth noting individual active managers of course can be. The active/passive debate will, however, undoubtedly continue with each side often taking pot shots at the other.
Here it should be noted the analysis is meant to be simplistic and of course comes with limitations. We have not, for example, looked at the dispersion of manager performance in a down year, which in theory should give greater scope for the better managers to outperform.
In addition, we have specifically looked at actively managed equity funds versus a comparative index (the benchmark), and not versus index funds, which of course will bear their own charges. We also have not considered fixed income funds, where arguably actively managed funds have more scope to provide downside protection by avoiding defaults.
Ultimately, we know that there are actively managed equity funds who can outperform their index and earn their Scooby Snacks. Investors and their advisers, however, need to decide whether it is worth paying the extra fees for the potential alpha a fund manager may or may not bring.