With the odds stacked against investors, the focus on picking funds should be on keeping costs as low as possible
Is active fund management worth paying for or should I stick with tracker funds for my portfolio?
Recent research has highlighted that just one actively managed UK fund manager has beaten the FTSE 100 index every year for the past decade. Although several managers have beaten the index for the majority of that timeframe, only Tom Dobell, manager of the M&G recovery fund, has achieved it year on year.
Given that an actively managed fund’s stated aim is normally to beat the index it is benchmarked against, a statistic like this at first appears shocking. However, this is a perfectly normal outcome. The mathematical chances of consistently beating an index over that sort of timeframe are extremely slim.
Up-front costs, high ongoing charges and other costs that do not even fall into a fund’s total expense ratio, such as trading costs associated with a high portfolio turnover rate, leave the fund, and the investor, on the back foot from day one.
Another is that most funds will own an average of around 100 companies, which means that any outperformance in the fund manager’s best stock picks is soon diluted.
This begs the question of why the fund manager holds so many stocks. The charitable reason is they need to for liquidity reasons.
Often, a manager will not be able to buy enough of a company they want to because they would either hold too much of the company or may not be able to buy the stock at what they deem to be a fair price.
The less charitable view is they hold so many stocks to track the market or, at least, to not risk getting a return that is too far removed from the norm.
Most active funds, in our opinion, are quasi-trackers that broadly mirror the market as a whole. The manager may take a few modest stock or sector bets but cannot afford to stray too far in case he or she picks the wrong ones. The result is an expensive fund that will have a few modest bets, none of which is likely to be enough to outweigh the costs.
We firmly believe in the concept of market efficiency, as well as the idea of the random walk.
The logic of the random walk is that if the flow of information is unimpeded, and information is immediately reflected in stock prices, then tomorrow’s price change will reflect only tomorrow’s news and will be independent of the price changes today.
But news is, by definition, unpredictable. None of us can predict what is going to happen tomorrow.
As a result, prices fully reflect known information and even uninformed investors buying a diversified portfolio should obtain a rate of return that matches that of the experts.
Our preference is to recommend a buy, hold and rebalance strategy, using passive funds to keep the cost of investment to a minimum. This will mean the portfolio goes up in the good times and down in the bad times. We would all like to make money when things are going down but we simply do not think this sort of absolute return strategy can be made to work consistently.
The focus should therefore be on keeping costs as low as possible. Is there any point in chasing alpha if the odds of actually achieving it are stacked against you? In fact, what is fundamentally wrong with getting the return, beta, that capitalism provides us?
Jason Witcombe is director of Evolve Financial Planning