My mum asked me if she should invest in Neil Woodford’s new fund. Like a bedazzled groupie she doesn’t stand a chance, given how he’s been marketed like a rock star who can print money.
Less sexy than Mr Woodford’s greatest hits – but compelling all the same – is research from Vanguard that states the case for avoiding active fund investing in the UK altogether.
While you can wallpaper your bedroom with this kind of evidence in the US, it’s a rare treat to get pro passive investing data that’s striped with the Union Jack.1
In The case for index fund investing for UK investors, Vanguard makes two powerful points:
- Active funds underperform index funds on average after costs.
- Some active funds can make dreams come true, but the persistence of winners is less reliable than a coin flip. So how can you hope to pick the superstars in advance?
Let’s take these one at a time to see just how strong the case for passive investing is.
Active funds underperform
Vanguard examined the 15-year track record of all the active funds available to UK investors that exist in the Morningstar universe, divided into various categories.
The broad sub-asset classes of global, UK, European, and emerging market equities were considered alongside global, pound-, dollar- and euro-denominated bonds.
The promise of active funds is that they can beat the market, because at the helm they have skilled managers who can deliver exceptional returns. That’s how they justify their high costs.
But Vanguard’s study shows that:
- More than 50% of funds failed to beat their own benchmarks in every single category over 15-years.
- In 10 out of 11 categories, more than 75% of funds failed to beat their benchmarks.
- Over 10 years, over 70% of funds lagged the market return in all 11 categories.
- Over five years, more than 50% of funds underperformed in all 11 categories.
That’s dismal.
“When you say they underperform…”
How badly are the fund managers doing?
Over 15 years the median fund manager is underperforming by anywhere between -0.18% to -0.89% on an annualised basis in every category bar UK equities.
In the UK the median fund manager has actually been outperforming by 0.32% per year, so there must have been some horrendous results booked in the bottom half the draw.
However those median figures don’t account for all the funds that were merged and liquidated over the course of 15 years.
This is known as survivorship bias. It makes the remaining funds look better than they really are because the overall figures are not dragged down by the poor returns of their eliminated fellows.
Picking winners
We’ve discussed the costs of underperformance before but, hey that’s okay. Just don’t choose a stinker, right?
Do your due diligence upfront, pick a fund manager with a stellar track record and a smart strategy, and you can forget all about average returns – or so the active fund management industry would have you believe.
Sadly, there’s a reason why all those brochures are made to carry the warning: “Past performance is not a guarantee of future results.” The fund manager league table is more brutal than trying to keep your position as top Christian versus the lions.
To test the persistence of manager’s skill, Vanguard ranked all equity funds by performance in the five years ending 2008.
It then looked at how the same funds fared over the next five years, to 2013.
As Vanguard puts it:
The results appear to be slightly worse than random.
While around 12.8% of the top funds remained in the top 20% of all funds over the subsequent five year period, an investor selecting a fund from the top 20% of all funds in 2008 stood a 65.4% chance of falling into the bottom 40% of all funds or seeing their fund disappear along the way.
- A fund’s chance of staying in the top tier over both periods = 12.8%
- A top tier fund’s chance of dropping into the bottom bracket or being closed = 48.1%
Only 2.6% out of 1,684 funds maintained their top tier status over the 10-year period.
What if you started at the bottom of the league? Well, 27.9% of those funds gained promotion to one of the top two tiers. But less happily, 51.9% were eliminated, and another 5% remained at the bottom of the heap.
These findings confirm earlier US studies that after accounting for risk there is negligible evidence that active fund managers can buck the market over prolonged periods, once you subtract their high costs.
The end of skill
One explanation for the failure of outperformance is that success itself is hardwired for self-destruction.
Larry Swedroe, in his book The Only Guide You’ll Ever Need for the Right Financial Plan
Who gets money to manage?
Well, since investors know who the skilled managers are, money will flow to the best manager first. Eventually, this manager will receive so much money that it will impact his ability to generate superior returns and his expected return will be driven down to the second-best manager’s expected return.
At that point, investors will be indifferent to investing with either manager and so funds will flow to both managers until their expected returns are driven down to the third-best manager.
This process will continue until the expected return of investing with any manager is the benchmark expected return: the return investors can expect to receive by investing in a passive strategy of similar riskiness.
No one doubts that some people exist who can deliver superlative returns.
The problem is you must identify them in advance to profit. You must get to them before their secret is out and the market heaps so much money upon them that they become closet trackers because their positions are so large.
Superior selection is a crapshoot for the average investor because what do you know that everybody else doesn’t? If you’re basing your decision on publicly available information then it will have already been consumed by big players who swarm over excess returns like piranhas sensing blood.
(Hint: Everyone knows about Neil Woodford.)
David Swensen, the manager of Yale’s endowment, had a chilling chapter on this problem in his book Unconventional Success
Swensen wrote:
Precious few investors enjoy the opportunity to gather direct evidence regarding a portfolio manager’s integrity, passion, stamina, intelligence, courage, and competitiveness.
The information most necessary for selecting superior investment managers remains inaccessible to nearly every market participant.
Seeing a glowing advert for a high-profile fund manager does not constitute gathering direct evidence, needless to say.
Passive investing wins
Even if you’re sceptical about research produced by Vanguard – which is after all the biggest purveyor of index trackers in the world – there are also plenty of industry insiders, such as Swensen and Warren Buffet, who also advise ordinary investors to put their money into passive investing.
The reason is that passive investing will provide you with average returns at a low cost.
Whereas active funds will in all probability provide you with average returns minus a higher cost.
You’ll probably get to keep more of your money if you choose the low cost route.
Take it steady,
The Accumulator
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Here, here!
If I get one more email, glossy brochure, pop-up message, or video (?!) telling me how I can (and why I should) cash in on NWs latest fund, I think I might screeeaaaam.
Apparently the folks at HL were working “all weekend” to answer our queries about it.. I wonder where they get the money to pay for that sort of dedication?!
Good article.
I was recently talking to a non financially literate friend who’s recently come in to some money. His IFA has kindly advised him to invest in all sorts of weird/wonderful and mainly very expensive funds.
I particularly like the point about how one should go about selecting a hot shot fund manager. We all know that past performance is no indicator of the future so if we accept that, then what possible reason is there to choose one manager over another once you’ve selected a strategy?!
I believe that if you want active management then invest directly. That way you’ll be able to fully understand the transaction costs and you’ll only have yourself to blame when it all goes horribly wrong!
The active manager retort to this is that the Vanguard research never weights these results by fund size.
I’d be really interested to see how this would change the outcome (if at all)
Whilst I don’t question in any respect the Vanguard findings, what is the real explanation for the oft-mentioned out-performance of UK investment trusts compared to the FTSE All Share index? There is an article at http://www.ft.com/cms/s/0/cf1f4eb2-77b3-11e3-807e-00144feabdc0.html#axzz34t95WzgK which mentioned it. (Can also be found by searching on ‘investment trusts trounce the opposition’).
I don’t find any of the explanations within the article totally convincing and I wonder whether the answer lies in structural and management differences between open and closed funds.
Yes, it would be interesting to see a comparison between trackers and investment trusts. My sense would be that the outcome would be a lot closer than the comparison with funds.
Well as a self-proclaimed bedazzled NW groupie, I’ve decided I’m going to take a gamble and stick a small amount in this new fund. Since this is going to be the last active fund I invest in, (I’m slowly converting all/most of my others into index funds and maybe ETFs), I hope that it’s not going to be among the 50% of funds that will consistently fail to beat its own benchmark!
Passive investment research must be like buses – this has been widely (slightly mis-)quoted in the press today:
http://pensions-institute.org/workingpapers/wp1404.pdf
“Abstract
This paper compares the two bootstrap methods of Kosowski et al. (2006) and Fama and French (2010) using a new dataset on equity mutual funds in the UK. We find that: the average equity mutual fund manager is unable to deliver outperformance from stock selection or market timing, once allowance is made for fund manager fees and for a set of common risk factors that are known to influence returns; 95% of fund managers on the basis of the first bootstrap and almost all fund managers on the basis of the second bootstrap fail to outperform the zero-skill distribution net of fees; and both bootstraps show that there are a small group of “star” fund managers who are able to generate superior performance (in excess of operating and trading costs), but they extract the whole of this superior performance for themselves via their fees, leaving nothing for investors.”
Oh and just seen this: http://www.telegraph.co.uk/finance/personalfinance/investing/funds/10904050/Just-one-fund-manager-in-100-beats-the-market.html
Here’s hoping that Neil is that ONE fund manager 🙂
@qpop – this research does weight performance by asset holdings – see appendix B.
@ grumpy – any vehicle can outperform if it’s measured against the wrong benchmark. A small-value fund should be held to account against a small-value benchmark not the FTSE All-Share or 100 etc. Also, many investments trusts use leverage. Risk-adjusted returns are important.
We hold a mix of Investment Trust and passive ETF trackers, and have observed that in general the ITs steadily outperform. This may be in part due to gearing, and certainly they are more sensibly structured than open funds (which includes ETF trackers( which have to sell stocks at the worst possible time to fund redemptions as investors stampede for the exit.
There is another issue of say when buying Russian or other less well researched areas of the world, where it may be preferable to have someone at the helm to screen out the duds. OK this goes against EMH.
So sitting on the fence on this issue, but am not about to dump ITs.
I too would be interested in seeing the comparison with investment trusts. I am 100% invested in investment trusts as I’ve believed all the articles (such as the one from the FT linked to above) which say that (unlike open-ended funds) investment trusts consistently outperform, so I get a bit nervous when people suggest that that is wrong….
@ The Accumulator — I understand your point about leverage and risk-adjusted returns, but I don’t understand your point about benchmarks. I know the linked FT article suggests that the difficulty of choosing a suitable benchmark could be a reason for investment trusts’ apparent outperformance, but I don’t see why that is exclusively a problem for closed-ended funds (as there are some open-ended actively-managed funds which also have wide investment remits). And if it is true that investment trust managers have — as a whole and over a long period — proven themselves adept at asset allocation as well as stockpicking, why be churlish about the fact that some of their gains are from shrewd asset allocation?
If a closed end structure were innately superior to open-ended then assets would flow out of open-ended products and they’d die off.
The evidence against active management is that the odds of outperforming consistently over time – after costs – are exceedingly small.
If ITs were different then they’d all be trading at vast premiums because money would seek their edge.
@ Alex – judging performance against an inappropriate benchmark isn’t exclusive to ITs. Many active managers would prefer to be judged against broader market benchmarks because then it looks like they outperform when in reality they bet on factors like value and small cap.
The point is that when you look at these returns on a risk-adjusted basis the managers don’t show persistent skill, after costs. Which raises two points:
1. Do investors know they’re taking extra risk to gain higher returns?
2. If your active manager can’t show skill then you might as well use a passive fund to take the extra risk because it will be cheaper and leave you with more return.
Regarding investment trusts out performance the obvious answer is leverage. I own about £30k of income growth Its. with most at premiums instead of discounts I cant see how they will outperform going forward as a matter of fact one of them Murray income is already fading in comparison to the allshare.
@The Accumulator,
Let me say at the outset that I have an open mind and am just seeking greater understanding.
Irrespective of performance, there are a number of reasons why investment trusts have not proven as popular as open-ended funds:
a) Commission payments meant that until very recently IFAs almost always sold unit trusts or OEICs in preference to ITs. However, they used to prefer insurance bonds because they paid even more commission!
b) Until recently, ITs could only be bought or sold via stockbrokers and most ordinary folk were not used to dealing with stockbrokers.
c) There was very little marketing of ITs presumably because the lower charges meant that marketing budgets were very small or non-existent.
d) The split capital scandal.
e) Concern about the greater complexity of ITs because of gearing and discount/premiums to NAV.
It will be very interesting to see what happens to ITs now that ITs are much more readily available on platforms. On the other hand, the difference in charges between the two families of investment vehicles is much less marked than pre-RDR.
@ Grumpy – the reasons you cite make sense for retail money – i.e. the likes of you and me – but not institutional money i.e. big players who spend a great deal of time hiring and firing managers.
Going back to the original issue viz:-active management v passive tracker. I believe the evidence in favour of passive investing in mainstream markets is overwhelming. But I want diversity in my portfolio. Perhaps some frontier markets or emerging Europe, where I can’t rely on my own skill and judgement. What then?
I wonder if anyone else is using the Motley Fool’s newsletter service, Stock Advisor. This is a US service recommending NYSE and NASDAQ stocks, and measures performance to S&P500. I have an Interactive Brokers account so I can trade these for only $1 a time. They form a nice part of my global diversification plan.
Motley Fool have reported results since 2002 which are very impressive. Hulbert’s Financial Digest has compared risk-adjusted returns of 200 US newsletters, and Motley Fool achieve top10 whether 1, 5 or 10 year comparisons. And (so far) always outperform the S&P including dividends.
I wonder what you would think about this, or perhaps this is material for a separate article? There are a lot of unhelpful discussions about this topic in the US sites, but I would love to hear the common sense considerations of The Accumulator or The Investor.
@ Alex, Old Paul
I have been investing in ITs for like nearly 30 years (I know)
Back when I started discounts were massive, my first purchases of RIT Capital Partners was at a discount to NAV of nearly 30% (back then it was only a medium sized IT)
Even huge trusts like F&C and Alliance Trust were sitting at 20%+ discounts
That coupled with lower fees than unit trusts, gearing and more exposure to overseas markets has helped the outperformance
Times moved on now, fees are converging, discounts have collapsed by my perspective
I switched to using mostly ETFs for my portfolio maybe 3-4 years ago now
If the discounts widened again I might get interested
I’m glad to see that Monevator is commenting on Neil Woodfords new fund considering the amount of hoopla in the press about this fund!! (I have no axe to grind either for or against Mr Woodford).
In an article by Louise Cooper in the business pages of The Times (20 May 2014) she reviewed the performance of Neil Woodfords old fund (Invesco Perpetual High Income) against the FTSE 100 and Vangurds FTSE UK equity income fund. The journalism in the article is a bit lazy and sneers about his investment style being faddy. The article didn’t consider the yields each fund has generated (the documentation on both shows about 4% historic yield), however the graphs in the article (generated by Trustnet) did show that the Vanguard fund had outperformed Neil Woodfords High Income fund – though there may be other factors such as the effect of Vanguards dilution levy
The clincher for me is the fees being charged for the new fund (Hargreaves Landsdown are quoting 0.60% plus their platform charge of 0.45% against Vanguards 0.25% plus platform charge) if I was to invest in a ‘value’ fund I know where I’d place my hard earned cash!!!
Thanks again for a highly informative investment site
I find all this persuasive: if I were a young thing investing pension money every month I’d use passive investing, at least for the developed, well-researched markets.
But I am a codger. I’m not sure that matching or beating the market matters much to me. What’s best for the risk-averse, especially those who are withdrawing some income/capital each year? Perhaps just diversify, with passive used for the equities fraction of the portfolio? Look at those Investment Trusts whose purpose is to avoid losing money?
Interesting that Aviva’s multi-manager team has given up trying to find US active managers that can beat the index, and they are struggling in the UK, though still trying:
http://www.investmentweek.co.uk/investment-week/analysis/2349874/fitzgerald-most-uk-managers-have-lagged-all-share-this-year?utm_term=&utm_content=Fitzgerald%3A%20Most%20UK%20managers%20have%20lagged%20All%20Share%20this%20year&utm_campaign=IW.Daily_RL.EU.A.U&utm_medium=Email&utm_source=IW.DCM.Editors_Updates
To play devil’s advocate, I guess an active management fan would say that it doesn’t matter that outperformance rarely persists in the very long term, as long as you monitor this and switch as necessary. Many advisers argue that they can successfully do this.
What I would like to see is proper analysis of whether there are advisors who have true skill in selecting (and, more important, deselecting) funds, adding persistent outperformance that more than compensates for the fees the adviser charges. I suspect the answer is no, if you dig below the surface. Such an analysis would have to look at long term performance, taking into account whether the adviser spotted a change in performance beforehand, rather than after it had happened, and including ALL fund recommendations made by the adviser, and adjusting for risk.
For instance, a while ago HL trumpeted that their Wealth 100/150 has far outperformed indexes since it started, because of their perspicacity in choosing which funds are in (and out). I can’t remember which index they used, but I think it was some mix of world indexes for equities and bonds. But I’m pretty sure it did not take into account that many of their selections are riskier than indexes (eg, small/mid-cap bias).
Perhaps another factor with ITs is that there’s an independent board who are responsible for overseeing the fund manager, negotiating terms and replacing them if they underperform.
@ivanopinion
As a mostly “enlightened” IFA, we did some research into a few portfolios (of active funds), which had produced steady outperformance over five years or so, to see what would have happened if we had just picked index trackers and made the same asset allocation calls, and the empirical evidence suggested the outperformance related to asset allocation, and the fund managers had added pretty much nothing, after charges, for their efforts.
Pretty eye-opening stuff!
Perhaps I missed it, but the Vanguard study seems not to adjust for the tendency for active funds to be riskier than their claimed benchmark index. As pointed out in the Aviva article that I linked, many UK managers using a FTSE All Share index benchmark are in fact biased to small and mid-cap constituents of that index. Companies below the FTSE 100 represent less than 20% of the FTSE All Share, by market cap, so these active managers are taking more risk than their index. This often boosts their performance, though this year it has held them back. Measured against the closest index, rather than the one the fund claims, active managers would be even worse.
@qpop
I admire your intellectual honesty. I’m sure most of the finance industry isn’t deliberately misleading clients, but there are probably things they choose not to think too hard about, because they don’t want to know the real answer.
@ Ivan – Advisors who can do this would effectively need the same skills as market-timers and stock-pickers and to be able to overcome yet another set of fees: their own. Large institutional funds can afford the very best advice to identify the best managers here’s a study showing that even they can’t get it right:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=994304
Abstract:
We examine the selection and termination of investment management firms by 3,400 plan sponsors between 1994 and 2003. Plan sponsors hire investment managers after large positive excess returns but this return chasing behavior does not deliver positive excess returns thereafter. Investment managers are terminated for a variety of reasons, including but not limited to underperformance. Excess returns after terminations are typically indistinguishable from zero but in some cases positive. In a sample of round-trip firing and hiring decisions, we find that if plan sponsors had stayed with fired investment managers, their excess returns would be no different than those delivered by newly hired managers.
Sorry, I’ve been away from this comments thread for a while so I realise no one may answer, but here goes….
In short, I fancy myself as being a fully signed up rationalist, both in my investing life and elsewhere. I do understand the rationalist case for index trackers, and I am therefore ready to be convinced that I should move my money into them. However, I am not fully convinced yet as there seems to be good evidence (viz. the FT article linked to above) that investment trusts do, unlike other types of actively managed fund, on average beat their benchmark.
I think, however, I am beginning to understand the passive case here — although it seems rather a subtle one. As I understand it:
(i) one reason investment trusts outperform is leverage. Nothing wrong with that per se, but it will increase volatility so the investment trusts versus trackers comparison simply isn’t comparing like with like.
(ii) investment trust managers often only reach higher returns by investing in a (usually higher risk) corner of their benchmark area — an obvious example would be where the benchmark is the FTSE All Share and the manager invests 95% of the fund’s money in small caps.
So…I understand why these points, but I still don’t quite see why they’re necessarily bad things. Leverage will almost certainly increase returns overtime, so for an investor like me who isn’t worried about volatility it’s definitely a good thing. As for point (ii), isn’t this exactly the sort of decision an active manager with a broad benchmark ought to be taking? Although I realise that a purist passive investor may want to do their own asset allocation, if an active manager can add value doing it then I’m happy to let them.
So…based on that, should I still switch to trackers? As I said before, I’m genuinely ready to be convinced as I do find the rationalist passive arguments appealing.
@Alex — Tangential question. Let’s say you had £200,000 in your pension, and you knew tracking the market would give you £400,000 in ten years time. Then let’s say actively investing in the same subset of stocks via Investment Trusts has a 60% chance of delivering the same return, a 20% chance of leaving you with £440,000 and a 20% chance of leaving you with £360,000.
How would you choose to invest? That might give you a clue as to your motivations.
Obviously you can’t know and I have made these numbers up, but my point is why do you want to beat the market?
I invest about 85% of my money actively these days, including in investment trusts. But while I hope to do better than the market *that is not the only reason why I invest actively*. I do it for a variety of reasons.
@Alex
Those things aren’t necessarily bad, but they do mean that if the IT “outperforms” the index with which it is notionally compared, this does not necessarily reflect anything more than the extra risk. So why pay extra for skill if you aren’t sure you are getting skill (or enough skill to justify the extra you are paying)?
However, some ITs have OCFs as low as 0.5%, which a rate few trackers could beat only a few years ago, and even now there are plenty that cost more. Other ITs have OCFs way over 1%, which is now looking very pricey, even compared to unit trusts.
If you are happy with extra risk, there may be cheaper ways to get it. eg, you can get your own leverage, by borrowing (at low interest rates) part of the money you invest. Or, invest in a tracker that tracks a higher risk index, eg, smaller companies.
Alex – re point ii, the manager shouldn’t be judged against a broad benchmark – they should be judged against the appropriate benchmark e.g. the FTSE Small Caps index.
If, as the evidence shows, most active managers will probably fall short of the appropriate benchmark then you’re better off choosing a lower cost option that will match it minus those costs.
Now, where that lower cost option doesn’t exist is where I have a decision to make. For example I invest in the Aberforth Small Companies IT in order to gain exposure to UK small value. This is an asset allocation decision not a vote for the skills of active managers. If a lower cost tracker option existed for that sub asset class then I’d take it.
Thank you all for the further comments.
ivanopinion — although I appreciate that there may be cheaper ways to get leverage, I’m not sure I’m ready to taken out a loan to fill up my ISA; it seems clearly higher risk than simply buying a leveraged investment trust as I could potentially end up owing more than I have!
To be honest, I think the real reason why I invest via investment trusts (making my own bold calls on allocations between investment trusts along the way) is because I enjoy it, rather than because I sincerely believe that I’ll necessarily make better returns than I would with a regimented system of low-cost passive investing (although, of course, I still hope my ultra-contrarian active IT strategy will pay off handsomely in the end).
Incidentally, are there any passive funds which use leverage? I have a feeling that there are leveraged ETFs but I don’t think they’re very popular or well-known. I understand that the only passive IT (Aberdeen UK Tracker) doesn’t use leverage. I’d have thought there could be more of a market for leveraged passive funds; perhaps even the extent of leverage could be decided passively as well so that the fund de-leverages when the index starts to look expensive (this could be done using a measure as simple as P/E ratio against a long-term average). Do any funds do something like this already?
Leveraged ETFs do exist but don’t work as most investors would expect i.e. you don’t earn the FTSE 100 x 2 because they reset on a daily basis (if my hazy memory serves) so gains don’t compound as you might expect. Providers seem to intend them to be used tactically rather than to achieve long-term goals which flies in the face of the passive philosophy. Bottom line is they’re only for very sophisticated investors who can take a punch in the gut. What I’ve read has convinced me not to touch them with yours 😉