In a year when markets have fallen and long-standing trends have gone into reverse, you might have expected active fund managers to have a field day compared to passive funds which blindly track the index.

But you’d be wrong. Just 27% of active equity managers beat a passive alternative in the first 11 months of 2022, according to AJ Bell’s latest Manager versus Machine report. That’s down from 34% in 2021. Clearly this is not a good result, but before you start ditching all your active funds and replacing them with trackers, there are some mitigating factors which need to be considered.

WHY UK ACTIVE FUNDS HAVE STRUGGLED TO OUTPERFORM

A lot of active manager underperformance came from the UK fund sector. Here, only 13% of active funds beat a passive alternative in 2022, compared to 41% last year. This is undoubtedly a very poor result but can be explained in part by active managers’ propensity to hold more small and mid-cap companies in their portfolio than a tracker fund, and consequently have a lower weighting to large blue-chip companies. It’s the latter which have held up much better in 2022, thanks to performance from the energy sector, as well as tobacco, defence and pharmaceutical companies.

The performance gap between the big blue chips of the UK stock market and more modestly sized companies has been stark in 2022. The FTSE 100 returned 6% between 1 January and the end of November, while the FTSE 250 mid cap index returned -16% and the FTSE Small Cap index returned -14%. It’s easy to see why a higher exposure to more modestly sized companies therefore hobbled the performance of active managers in 2022.

Over the long term, hunting further down the market cap scale has been a positive tailwind for active managers in the UK, because over 10 years, the FTSE 100 has returned 89%, whereas the FTSE 250 has returned 106% and the FTSE Small Cap has returned 152%. That goes a long way to explaining why six out of ten active managers have outperformed a passive alternative if you look at returns across the last decade.

A GOOD YEAR FOR US-FOCUSED ACTIVE MANAGERS

It’s not been all bad news for active funds either. Those active fund managers plying their trade in the US actually had a relatively good year. Forty percent of active managers investing across the pond outperformed a passive alternative in 2022. That may not sound like a victory for active managers, but it compares to only 19% performing the same feat last year.

In 2022, US active managers had to navigate a sell-off in the tech sector, which seriously dented the share prices of some of the behemoth companies in the US stock market, like Amazon (AMZN:NASDAQ). These mega cap companies are so big, tracker funds invest quite heavily in them, seeing as they usually replicate the market according to company size, so poor performance from these stocks has given active managers with less exposure a bit of a leg up this year.

The growth of passive investing has pumped some fresh life into the UK’s investment industry in the last 10 years; not so much for active fund managers, but for private investors. It’s provided everyone a way to get simple exposure to markets at low cost. But unfortunately, not all passive funds got the memo.

WHY SOME PASSIVE FUND CHARGES ARE A RIP OFF

Data from the Manager versus Machine report shows there is quite a wide range of charges levied by tracker funds, and a pretty egregious premium charged by some tracker funds in the UK All Companies sector. Here the cheapest tracker fund comes with a price tag of 0.05% per year, and the most expensive charge levied for a fund in this sector is 1.06% per year. In other words, the most expensive UK tracker fund costs 21 times more than the cheapest.

Unlike with active managers, there can be no attempt to justify higher charges through superior performance potential, seeing as these funds are doing a very similar job of tracking an index. To put this in pounds and pence, an investor who switched £10,000 from the most expensive UK tracker fund to the cheapest would be £6,627 better off after 20 years, assuming a 7% gross return from the market. There can be little reason for investors not to make such a rewarding switch.

Overall, the picture in 2022 has been pretty discouraging for active investors. However, it’s important to set expectations appropriately. Clearly not every active manager can beat the market, and in a ‘neutral’ scenario you would expect around half to outperform and half to underperform, before charges.

Things look better over the longer term for active managers with 39% outperforming over 10 years, and that figure stood at 56% in 2021, which goes to show that even long run performance can be heavily impacted by recent market movements.

Investors needn’t be dogmatic about sticking to only active or passive funds, in fact they might choose active managers in some regions and passive funds in either, depending on where they think active managers have a better chance of outperformance, or based on their conviction in the prowess of particular fund managers.

By picking competitively priced tracker funds, and supplementing this with a bit of judicious active fund selection, investors can give themselves a good chance of achieving portfolio outperformance in the long run, through a combination of both active and passive strategies.

DISCLAIMER: AJ Bell owns Shares magazine. The editor of this article, Tom Sieber, owns shares in AJ Bell

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