In defence of active management

A study by the Cass Business School recently claimed that just one in a hundred fund managers consistently beat their benchmark. It suggested that investors would be better off investing in passive index trackers, which charge lower fees.

The Cass study is not alone, other articles and research have criticised the active fund management industry, implying it offers no value for investors, and very little has been said in active managers defence. The industry has been almost deafening in its silence. So why is this?

It is true that the average passive fund outperforms the average active fund. Active funds make up a large part of the market and all compete with each other. Some active funds will win and some will lose, but the average fund will underperform a passive fund because it charges higher fees.

Closet Trackers

Here is a secret though, the average active fund performance is dragged down by closet tracker funds. A closet tracker fund is a fund which purports to be actively managed but in reality sticks very closely to the benchmark. Because of the high fees these funds charge they are often guaranteed to underperform their passive counter parts.

A famous study of US mutual funds by Antti Petajisto and Martijn Cremers showed that the number of these funds had grown enormously over 30 years. Today over 30% of US based funds are closet trackers*. The study used a new measure to calculate how much a fund differs from its benchmark, called active share. The simple intuitive measure calculates how the percentage of stock holdings in a manager's portfolio differ from the benchmark index.

 More Active Managers Outperform

The lesson for any investor is to make sure your fund is not a closet tracker. Although the initial study was done in the US, research shows a similarly surprisingly high number of closet tracker funds in the UK too, often managing billions of pounds of assets.

However, what the US study also found was that the more active, or different to the index a fund was, on average the more it outperformed. This makes some sense, the more active the manager the more confidence he must have in his own ability. Amazingly the study found that on average the most active fund managers beat the market and passive funds returning over 1% per year more than their index even after fees. A surprising number, perhaps, given all the recent press and negativity surrounding active management. But then a good news story never sells as well as a bad news story. And it worth remembering that a true passive fund will always underperform its index, it won't match it.

Whilst there are many closet tracker funds around there also many brilliant managers, fund providers and research teams who add real value for their investors. These funds have high conviction and typically have the courage to divert significantly from the index. Some of their results have been spectacular. The key is identifying them.

Chelsea's own Core buy list, composed entirely of active funds, has easily beaten its index. We calculated the performance of the Chelsea Core Selection (35-40 funds) over the past 10 years, taking into account when old funds left and new ones were added. The Core Selection beat the IMA Flexible sector by 45%*, outperforming almost every year after all fees.

Don't believe those who tell you that active funds can't beat passive funds. There are many funds and managers which have proven that this isn't true over very long periods. And its not just Neil Woodford who has managed it despite his heavy press coverage. Below are just a small handful of the managers who have significantly outperformed the market over a ten year period and have also featured on the Chelsea Core Selection at some point.  These managers have delivered consistently high alpha, often generating better returns than their benchmark indexes with lower volatility.

Angus Tulloch (Asia Pacific Leader)
Giles Hargreaves (Marlborough Special Situations)
Nigel Thomas (AXA Framlington UK Select Opps)
James Thompson (Rathbone Global Opps)
Richard Buxton (Schroder UK Alpha & now Old Mutual UK Alpha)
David Dudding (Threadneedle European Smaller Companies & Threadneedle European Select)
 
In a future post, I will explain how you can identify a closet-tracker and I will name and shame some of the worst offenders.

By James Yardley, research analyst, Chelsea