By PATRICK CAIRNS
Suppose that you needed to rent a car for the weekend, but you could not find a rental company able to guarantee the kind of vehicle you were going to get. You could be given anything from a Citroen C1 to a Mercedes A class, and you would not know what it was going to be until you showed up to collect the keys.
While this scenario might be disconcerting, at least choosing which firm to use should be straightforward. All else being equal, you should go with whoever charged you the lowest fee.
This is common sense when none of them can be certain of what they will be able to deliver. There is no point in paying more if you can’t be sure that you are going to receive extra value for that money.
Yet, this is how the fund management industry has worked for decades. Active managers have been charging high fees for their products even though there is no way anybody can be sure of the outcomes that they are going to be able to produce.
What are active managers selling?
The rationale for this is that active managers offer the potential to out-perform the market. That is their selling point – you pay more because active management is the only way that your money can grow ahead of the benchmark. This is why so many investors and advisors fret over performance tables and fund ratings.
However, every genuine fund manager in the world is very careful to point out that not only is past performance no indicator of future returns, but that no level of performance is ever guaranteed. Given the vagaries of the market, it is simply impossible for anybody to know how any fund is going to perform into the future.
This hasn’t, however, stopped active managers from promoting out-performance as their unique selling point. It was what almost every active manager in the world strives to deliver.
The irony, of course, is that this is obviously unobtainable. It is impossible for every active fund to outperform. Simple mathematics dictates that if the benchmark is the average return from all active managers, then there must always be under-performers.
What does the evidence show?
As an increasing amount of research continues to show, these underperformers are actually the bulk of the market. Far more active managers are on the wrong side of average than the right side of it.
The most recent S&P Indices Versus Active (SPIVA) scorecard shows that over the 10 years to the end of June 2019, only 25.66% of UK equity funds out-performed the S&P United Kingdom BMI. In other words, just under three-quarters did not.
SPIVA scorecards calculated in markets around the world all show similar patterns. So too does Morningstar’s Active/Passive Barometer.
Although this is only calculated for the US market, the most recent Morningstar barometer shows that only 23% of all active funds in the US beat the average of passive funds over the past decade. For US Large Blend Equity Funds, the figure is only 8%.
Where is the value for money?
Given this success rate, it should be obvious to active managers that what they are selling is not deliverable. It is much like a car rental company charging you for a Mercedes A class, even though it couldn’t be sure that you would actually be given one. A company that did that would surely find itself out of business fairly quickly.
Yet, active fund managers continue to sell the idea of out-performance, even though more and more investors and advisers have begun to understand the research — that beating the market is extremely difficult to do, and improbable over the long term.
That is why there is now more money invested in passive funds than in active funds in the US. That milestone was reached in August last year.
Investors and advisers appreciate that the value proposition of index tracking funds is one that actually can be delivered consistently — to produce the return of the market, minus fees. It is understandable, straightforward, and reliable.
It is like the comfort of going to a car rental company and being given the keys of the vehicle that you actually booked. You should, after all, get what you pay for.
One of South Africa’s most respected financial journalists, PATRICK CAIRNS is a trusted commentator on the world of investments and the quirks of behavioural finance. Over more than a decade he has built a reputation for keeping the industry honest, and putting the interests of investors first.