Just a third of active fund managers outperform passives

AJ Bell’s latest Manager versus Machine report paints an alarming picture for active managers, who are struggling to beat tracker funds on performance, and are losing hands down when it comes to attracting investors’ money.

The report looks at the performance of active funds across seven equity sectors and compares them to the average passive fund in each sector (see table). Only 35% of active equity funds beat the average passive fund in their sector in the first half of 2024, and the same proportion, 35%, outperformed over the past 10 years.

It wouldn’t be at all surprising if active managers were starting to feel like an endangered species. Not only is performance flagging, but passive funds are winning the battle for hearts, minds and wallets. Retail investors put £37 billion into tracker funds since the start of 2022, while at the same time withdrawing a staggering £89 billion from active funds, based on Investment Association data. These are absolutely unprecedented outflows, and compound the performance woes experienced by active managers.

Tech on top

Weak relative performance by active managers isn’t entirely down to stock selection skill, or lack thereof, because some pretty stern headwinds have been battering active funds. Most particularly the continued dominance of big US technology stocks continues to pose existential questions for managers in the key Global and US equity sectors. Taking these two sectors out of our analysis, the proportion of active managers outperforming over a 10-year period rises to a more respectable 46%, within a statistical whisker of the 50% that might be expected in normal conditions.

As Terry Smith points out in his latest letter to Fundsmith Equity shareholders, just five big tech companies were responsible for 46% of the returns of the S&P 500 index in the first six months of this year, with Nvidia being responsible for 25% of the returns. Failure to hold a full market weight in the top performing technology stocks has therefore been a costly enterprise for active managers this year, and over the past decade. But to match a passive fund’s exposure, an active US equity fund would now have to hold 32% in the Magnificent Seven stocks, with 7.2% in Microsoft, and 6.6% in each of Apple and Nvidia. Those are pretty punchy positions for an active manager to adopt, with the unsettling result they would simply be in line with the rest of the market on that portion of their portfolio.

The same problem impacts global fund managers because the S&P 500 now makes up around 70% of global stock market capitalisation. Despite the fact active managers have in large part failed to outperform their passive rivals in the Global and US sectors, investors may be buoyed by the not inconsiderable consolation that returns have still been exceptionally strong. The average active US fund has returned 278% over the past 10 years, while the average active Global fund has returned 173%.

Pension fund performance

For the first time our report includes insurance company pension funds, which unfortunately have done even worse than standard funds. Just 24% of active pension funds in our sample outperformed the average passive fund, adjusted for platform charges to put them on a level footing. Drilling down further, this includes just 9% of global funds, 14% of US funds and 20% of UK funds.

This is just one reading, but there are a number of reasons that might explain the weaker performance of pension funds. Many will have been around for a long time and so may carry higher charges. Some may be closet trackers, making only small deviations from benchmark indices but charging active fees nonetheless*. Some of these funds will be closed to new business, so there may not be a large incentive for providers to invest lots of resources in improving performance, especially when there is low engagement from investors and so little chance of them transferring their pension away.

*Data to 30 Nov 2023

Passive investors face active choices

While it’s easy to laud the low costs and simplicity of index trackers, investors do need to bear in mind that not all passive funds are created equal. Even with the same market, passive funds can elect to follow different benchmarks that can result in performance gaps. For instance, in the global fund sector, a tracker fund following the S&P Global 100 index returned 315% over the past 10 years, in comparison a passive fund tracking the FTSE World Index returned 214%. This highlights that tracker funds aren’t one homogenous lump, and passive investors still face some active decisions.

While no-one can predict which index is going to perform best, one thing we do know for sure is that higher charges will erode returns. In the UK one fund tracking the FTSE 100 has turned £10,000 into £17,940 over the past decade, and another following precisely the same index has turned that same sum into just £16,400. The former charges just 0.06% per annum, the latter 1.06%. Again, this shows that passive investors need to keep on their toes. Seeing as funds following the same index should perform very similar jobs, investors holding expensive tracker funds can achieve better long-term returns by simply switching to a cheaper competitor.

Active or passive?

Our Manager versus Machine report covers seven equity sectors, and there are areas where passive strategies are less common, or more complex, and where active management can still lay claim to some higher ground, for instance funds targeting income, low volatility or investing in smaller companies. We should also acknowledge that the market return itself is partly a function of active managers collectively allocating capital, and all market participants, including passive funds, benefit from that.

The more investment that flows into passive funds, the more money is allocated to companies purely based on their size, and while that has been a winning trade for the past 10 years, it won’t strike most people as a foolproof way to pick winners.

Sources for performance data: AJ Bell and Morningstar, total returns to 30 June 2024

Sources: AJ Bell and Morningstar, total return to 30 June 2024