Will 2018 be the year of the active fund manager?
Commentators love to claim that actively managed fund performance generally fails to justify the higher annual management fees the fund managers charge for their stock picking choices, in comparison to their passive, index-replicating cousins.
However, the performance of the active fund industry is not as abject as some would have you believe. An average of nearly 50% of managers investing in UK equities have outperformed the market in each calendar year since 1997.
Over a three-year rolling period, this figure rises to 52%. Over a five-year period, the percentage is 54%. Therefore, on average over the past 20 years, there is a 54% chance that over a five-year period a randomly chosen active fund manager would have delivered outperformance.
At CGWM we don’t allocate to fund managers randomly, but invest following extensive quantitative analysis of their stock picks and qualitative due diligence – so we would expect to meaningfully improve on this expected hit rate.
Not all actively managed funds were created equal
It’s not always the same active fund managers who outperform. Active fund manager A may have outperformed in 2015, but underperformed in 2016. Active fund manager B may have underperformed in 2015 and outperformed in 2016. In a peer group of just these two active fund managers, on average 50% outperformed each year, but neither outperformed in both periods.
This often underlies criticism of the active fund management industry. For example, analysis reveals that a particular active fund manager made the best stock picks and outperformed in four of the last five calendar years. Because of the one year of underperformance, the fund manager is viewed as having ‘failed’ and seemingly cannot justify the higher management fees charged in comparison to passive vehicles.
This is a facile argument which fails to consider two things. First, no investment should be viewed as a success or failure when measured over just one year. Second, it takes no account of the margin of out or underperformance. If said active fund manager outperforms by 1.5% each successful year on a net of fees basis, but underperforms by 4% in the more difficult year, over the five-year period as a whole, the fund would still have delivered outperformance of 2%.
The blame game
The number of active fund managers who outperform in any period varies; the shorter the period, the greater the variability in the number of active fund managers who beat the market. Reviewing the UK peer group again, the highest percentage of active fund managers who outperformed in any one calendar year was 85%, in 2013. Over three years, the highest is 82% (June 2012 – June 2015) and over five years it stands at 76% (November 2011 – November 2016). On the other side of the equation, just 15% of active fund managers outperformed in 2016, while the lowest percentages over three and five years stand at 27% and 28% respectively.
How hard can it be?
What dictates how easy or hard it may be for active fund managers to outperform? Essentially it boils down to three things – efficiency, market volatility and correlation.
Stock market efficiency is the degree to which stock prices reflect all available, relevant information. The US is generally viewed as being the world’s most efficient stock market and therefore, by definition, the most difficult to outperform as there are fewer inefficiencies on which an active fund manager can capitalise.
Whereas, on average, 49%, 52% and 54% of UK funds outperform over one, three and five years, these figures drop to 43%, 44% and 45% when considering managers who invest in US equities relative to the S&P 500.
The latter two factors – market volatility and correlation – stand behind our conviction that 2018 will be a year when active fund managers prove their worth. Both high market volatility and low correlation provide tailwinds for outperformance; tailwinds which were lacking in 2016 but which we believe will re-emerge in 2018.
Market volatility and correlation
Greater market volatility allows active fund managers more opportunities to buy stocks when they have fallen significantly and/or sell assets which may have risen meaningfully. In a becalmed sea, the ability to add value by trading shares is limited.
Similarly, if most stock prices are moving together, the potential to add value by identifying ‘good’ companies for stock picks and avoiding ‘bad’ companies is also limited. The active fund manager does not want the price of everything to move in tandem – but that’s what has been happening until recently.
So – are actively managed funds worth it?
There has been a welcome, sharp fall in stock correlations, which bodes well for the active fund industry. Market volatility, as measured by the VIX index, has been trending lower over the past few years. However, with central banks now beginning to remove policy accommodation and valuations elevated in many areas, we believe market volatility may well break its downtrend.
Both developments bode well for active fund managers. The best, we believe, will justify their worth in 2018.
What is an actively managed fund?
An actively managed fund is one where a person or people (i.e. a single manager or a pair or team of managers, and definitely not a computer) actively manage the portfolio of investments within the fund.