My mum asked me if she should invest in Neil Woodford’s new fund [1]. 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 [2] data that’s striped with the Union Jack.1 [3]
In The case for index fund investing for UK investors [4], 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 [5] 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 [6]. 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 [7] 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 [8]
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 [9] 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 [10]
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 [11] in the world – there are also plenty of industry insiders, such as Swensen and Warren Buffet [12], 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.
[13]
You’ll probably get to keep more of your money if you choose the low cost route.
Take it steady,
The Accumulator