The vast majority of actively managed funds underperform the market index. This is not a surprising statement of fact – active fund management involves significantly higher fees than index funds (or passively managed funds), higher transactions costs (due to frequent trading) and increased tax liabilities (again due to the frequency of trading).
Of course some actively managed funds do outperform the market (in a net return sense). Yet an investor does not know ex ante which active fund managers will outperform the market in any particular year or over several years. A funds manager may outperform the market for several years yet sink below subsequently.
Past performance, after all, is not a reliable guide to future performance, although it is frequently the only guide available.
According to the ABS (Cat No. 5655.0), in the June quarter 2013 the consolidated assets total managed fund industry in Australia was $1.7 trillion (ie: $1.7 * 10^12). This includes both actively and passively managed funds. This is a hefty sum (no wonder the former government was eyeing it off).
Small differences in net returns make substantial differences to the overall return an investor achieves. Returns which over a long period can significantly affect the wellbeing of a retiree and his or her call upon government social security.
That is why we need a competitive and transparent funds management industry, where investors are reliably informed of fee structures and fund performance in a relative sense, both against other actively managed funds but also against various index funds.
No doubt the debate about the relative merits of active versus passive funds management will continue. Some will argue that the additional fees charged by active fund managers are a justifiable return that reflects the ‘value’ added by the relevant manager.
I’m not in that camp – I think that for most investors the use of pure passive funds management would make them better off.
However, there can be no doubt that those managers who charge active management fees yet in practice offer an investment that is merely following the index are ripping off their clients. This is known as ‘closet indexing’.
A report by SCM Private, a London-based investment adviser, found that half of all UK active managed funds are closet indexers. This trend is described as a
scandalous index cloning epidemic
After analysing £120 billion of UK funds, SCM Private found that investors could have saved £1.86 billion in fees if they had moved to pure index funds rather than these closet indexers.
As noted by John Authers in the Financial Times, the incentives to ‘active’ fund managers is not to outperform the market but to accumulate assets
This is because they charge a percentage fee on assets under management and are judged by comparison with their benchmark index and with their peers. To hold on to assets, therefore, it is vital not to underperform peers. Make a big contrarian bet and you may be separated from the herd. So everyone herds into the same stocks.
On average, active management fees (by genuinely active fund managers and closet trackers alike) are three times those of index funds. It is clear that one should avoid closet trackers.
Caveat: I am not a licensed investment adviser. This blog is not meant to provide individual investment advice, but merely to discuss active and passive funds management.