Every six months at AJ Bell, we publish a report on the proportion of active managers beating the typical passive fund in seven key equity sectors. It’s called Manager versus Machine, and ever since we launched the report in 2021, it has made challenging reading for active managers. In the latest edition, our analysis showed that overall, just 33% of active equity funds outperformed the typical index tracker in their sector (see table).

That doesn’t sound like a good result, and it isn’t. But it’s probably better than you think. All active managers aim to outperform, and all investors in active funds want them to, but it’s simply not possible. Broadly speaking, the buying and selling activity of all investors, including active fund managers, dictates what the market return is.

Consequently, some will be on the wrong side of the market return, some on the right side. A reasonable result would be for somewhere around half of active managers to outperform a passive alternative. That would mean the blind choice between active and passive funds is a coin flip, and with some judicious fund manager selection, investors could actually tilt the odds in their favour so that more active funds in their portfolio outperform than underperform.

ACTIVE MANAGERS HOLDING OWN IN SOME AREAS

As the figures from our Manager versus Machine report show, that is some way from being the case overall. However, there are some areas where active managers have held their own against the passive machines over 10 years, notably funds investing in Europe, Emerging Markets, and Japan.

The real areas where active managers have been routed by index trackers is in the US and Global sectors, where just 23% and 17% of active managers have outperformed a tracker in the last decade. There are a lot of funds in these two sectors, and so results here really have a big impact on the overall figures. Looking at active equity funds without these two sectors, the number outperforming a passive alternative rises to 44%. More respectable, if not tub-thumping.

Without getting too precise, there are seven reasons which largely explain why active funds in the US and Global sectors have done so poorly compared to index trackers. They are the group of stocks known as the Magnificent Seven.

These US technology stocks have dominated stock market performance for a long time now. Nvidia (NVDA:NASDAQ) alone accounted for 20% of the rise in the S&P 500 (the main US stock index followed by trackers) in 2024, according to numbers calculated by Fundsmith.

If you didn’t hold Nvidia, or perhaps only held a little, outperforming becomes very difficult. This applies to active managers in the Global as well as US sector, because the US stock market now makes up around 75% of the world stock market, again mainly because of the strong performance of the Magnificent Seven.

REASONS FOR UNDERPERFORMANCE

There’s nothing stopping active managers holding these companies. Many do. But these tech titans have become so dominant that the amount invested by index trackers is unlikely to be matched by active investors. At the beginning of 2024, the typical S&P 500 tracker held 28% of its portfolio in the Magnificent Seven tech stocks, with 7% in each of Apple (AAPL:NASDAQ) and Microsoft (MSFT:NASDAQ).

Some, but by no means all, active managers might be willing to hold such large positions in the companies they have the highest conviction in. It would be some coincidence if their research led them to invest in every one of the Magnificent Seven though.

Any active fund which did hold the same amount in the Magnificent Seven as a tracker fund would also be guaranteeing underperformance on that portion of their portfolio. That’s because performance would be the same as a tracker fund before fees, and so less after fees, as active managers charge more than (most) tracker funds.

The rest of the portfolio would therefore have to do a lot of heavy lifting to generate outperformance for the fund as a whole. Indeed because of the strong performance of the Magnificent Seven, US index funds have become even more concentrated, with the typical US index tracker holding 33% of their portfolio in these seven companies as at the end of November.

So, does this mean fund investors should simply steer clear of active funds? Based on the amount of money that is flowing out of active funds and into trackers at the moment, undoubtedly some people are. But the high concentration of Magnificent Seven stocks in US and Global trackers does provide some cause for concern about concentration risk when it comes to funds tracking these markets, especially when these companies are trading at high valuations.

Bear in mind that index trackers aren’t investing lots of money in these companies because they’re great businesses, but simply because they’re very big businesses. If the Magnificent Seven continue to perform well, we can expect trackers to keep beating active funds around the park. But if there is a correction in the technology sector, passive funds will probably be hurt the hardest.

NOT JUST ABOUT PERFORMANCE

Whether you invest in active or passive funds doesn’t just come down to performance. If you don’t feel confident picking active funds, then tracker funds are the way to go. But if you are willing, keen even, to roll up your sleeves and pick out active managers who you think can deliver outperformance, then there’s a good case you should so with at least some of your portfolio. Remember you don’t have to hold all of your money in either active or passive, you can have a bit of both.

Blending them together mitigates the impact of any underperformance from active managers, and also helps to hedge the concentrated stock and sector risk currently at play in Global and US tracker funds.

DISCLAIMER: AJ Bell owns Shares magazine. The author (Laith Khalaf) and editor (Tom Sieber) of this article own shares in AJ Bell.

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