Investors losing faith in active fund managers

If you can't beat the market, track it. That's the stance increasingly being taken by ordinary investors who, disillusioned by fund managers' horrific performance in 2014, are migrating out of active stock-picking funds and into low-cost passive strategies.

Active fund managers needed a good 2014, having underperformed badly in recent years. Instead, some estimates suggest that only one in 10 US large-cap funds outperformed the S&P 500 in 2014 – the lowest percentage on record.

Little wonder, then, that investors are increasingly opting for low-cost passive strategies that aim to capture market gains. Index fund group Vanguard is now the largest fund firm in the world, managing more than $3 trillion in assets and taking in a record $243 billion in 2014 alone.

In the US, almost $92 billion was withdrawn from active funds, while passive funds attracted inflows of $156 billion.

In Europe, too, the passive approach is gaining ground. Vanguard’s European stock index fund is the continent’s biggest equity fund, managing more than twice as much money as the biggest active fund in the region. Overall, inflows into Vanguard’s non-US business more than doubled last year.

Lipper data indicates a similar picture for the UK, with money flowing into passive funds but more than $17 billion being pulled from active funds.

The move away from active funds has been catalysed by years of underperformance. Just 35 per cent of active UK funds have outperformed over the last decade, while only a fifth of European funds have outperformed their benchmarks over the same period.

In the US, large-cap fund investors have done particularly badly – according to an S&P Indices report last year, 87 per cent underperformed over the previous five years. Strikingly, of 17 different categories of equity funds tracked, there was none where more than half of funds outperformed over the five-year period.

Will work for food

Among the investing public, there is an increased awareness of the shortcomings of the active approach. Media headlines last year included “The decline and fall of fund managers” (

Wall Street Journal

), “The triumph of index funds” (

Time

), “Who routinely trounces the stock market? Try 2 out of 2,862 funds” (

New York Times

), and “Will work for food”, the

Economist

’s pithy take on the seemingly bleak future awaiting active fund managers.

Warren Buffett’s announcement that his will contained instructions that 90 per cent of his fortune be put in an S&P 500 index fund also hit the headlines. That helped swell the coffers at Vanguard, which predicted that Buffett’s recommendation would “resonate for years”.

However, while 2014 was in many ways a landmark year for passive funds, the move away from traditional active funds has been evident for many years now. According to research firm Morningstar, more than $1 trillion has been pumped into passive equity funds since 2009. In the US, the percentage of assets invested in passive portfolios has more than tripled from 9 per cent in 2000 to 28 per cent today. About a quarter of UK assets are now invested passively, compared with 15 per cent a decade ago.

The poor investment returns on offer over the last 15 years have been a large factor in the growing disillusionment with conventional stock funds. Paying 1.5 per cent in annual management fees may not have seemed that high back in the 1990s, when US stocks enjoyed average annual gains of 17.6 per cent. Since 2000, however, annual gains have been closer to 4 per cent in the US, and much lower again in Ireland, Britain and Europe. If annual returns are averaging 4 per cent or less, annual fees of 1 or 2 per cent no longer seem trivial.

In fact, the nature of compound interest means the true costs of annual fees is even more damaging than they may appear. Over 30 years, a €1,000 investment compounding at 6 per cent a year will grow to €5,743. A 2 per cent annual fee would reduce that figure to €3,243, erasing nearly half of one’s gains.

The explosive growth in exchange-traded funds (ETFs) has also helped fuel the migration in assets. ETFs offer access to international indices at rock-bottom rates, often at 0.10 per cent or less. More than $2.5 trillion is now invested in ETFs, a sixfold increase since 2005.

Woodford success

None of this means the active fund investment industry is dead. After all, passive investing remains a minority approach, and some superstar fund managers continue to attract large-scale investor interest. For example, money has flocked to

Neil Woodford

, the best-known fund manager in the UK, since his CF Woodford Equity Income fund was launched in June. It has been the most-bought fund in the UK for each of the last five months, attracting more than £2.6 billion in inflows since its launch.

However, Woodford is no ordinary investor. Since launching his new fund, he has complained that fees in the industry are too high, especially when many funds are simply closet trackers that attempt to hug their benchmark index (Woodford’s fund charges 0.75 per cent per annum, well below industry norms).

Additionally, whereas most managers disclose only their top 10 holdings, Woodford reveals his entire portfolio, and the percentage each stock occupies in his portfolio, every month. He also explains why he buys or sells a particular stock, saying investors “have a right to know what we’re doing with their money”.

Competition

More active managers will need to follow Woodford’s example in coming years. The focus on fees is only going to increase, given that indexing giants like Vanguard, Blackrock and

State Street

continue to lower costs in their fight for market share.

Additionally, active managers will need to be more transparent and articulate exactly why investors should trust them with their money, given that so few manage to secure market-beating returns.

Not only are they up against low-cost index funds, they also face competition from semi-active ETFs which take an alternative approach to indexing, with constituent stocks being weighed by fundamental factors such as dividend yields or price/ earnings ratios. Such funds offer the potential for market-beating returns, but their passive and mechanical nature means costs are kept low.

Any move away from investment- related commissions, too, will put pressure on the industry. In Ireland, financial advisers may be paid a commission if they persuade a customer to opt for a particular pension or investment.

However, the commission model has been banned in the UK since 2013, after a review of the industry by the Financial Services Authority. Other countries are conducting similar reviews; by 2020, according to accounting firm PricewaterhouseCoopers, most developed countries will likely have introduced similar rules and that will only accelerate the move towards the low-fee investing model.

For now, active managers will console themselves with the thought that 2015 may prove less stressful. It can hardly be worse than 2014, when various factors combined to ensure historic levels of underperformance.

Fleeting reprieve

However, any reprieve is likely to prove fleeting. The multiplication in available low-cost options – both passive and semi-active – means the old “trust us, we’re the experts” approach appears increasingly outmoded.

To survive, active managers will have to take a leaf from Woodford’s book and prove their worth. Those that cannot do so face being put out of business by the passive trend that shows no sign of ending any time soon.