All key regional and global equity indices have delivered positive returns (in sterling) to date in 2014.
Yet, it has been a bad year for the active fund management industry.
Across many key equity sectors, more than two-thirds of funds are underperforming mainstream benchmarks.
With the exception of the US, most of the representative benchmarks have posted single-digit growth in 2014. The extent of underperformance from the average fund is especially significant, as it erases most positive performance from equity allocations.
The proportion of funds underperforming within each sector is close to the extremes witnessed in the past decade. However, it is not out of keeping with the worst of the reversals suffered in the past: 2007, 2008 and 2011 were similarly challenging.
This year’s challenges have come after active managers enjoyed an unusually prolonged period of success in 2012-13. It was the first time in more than 20 years that mainstream UK equity indices had been outperformed by more than 65 per cent of funds for two successive years.
In 2013, three-quarters of funds outperformed, and the sector average outpaced indices by more than 550 basis points.
The 2012-13 period was indicative of the fact the IMA sectors typically outperform market benchmarks during positive market conditions. This is partly due to many managers’ reliance on mid and small caps to outperform. These stocks are often more volatile during periods of market crisis, hence the relative weakness from most of the mainstream equity sector averages in 2008 and 2011.
It is unusual that 2014 has been such a difficult year for active managers in spite of positive performance from most global equity markets. It is at least partly attributable to the abnormal nature of the post-crisis environment.
It is unsurprising that the benchmark ranking within sectors tends to fluctuate over time. In the past 20 years, indices have not sustained top- or bottom-quartile performance in successive years.
The majority of active funds’ performance can be explained by persistent style biases rather than flexible investment approaches. As a result, their performance oscillates according to the styles that lead equity markets during different time periods.
There is speculation that the underperformance this year of active funds, and many macro hedge funds, will encourage fund managers to increase portfolio risk, pushing equity markets higher in the final months of the year.
The strong rally in the fourth quarter of 2011, a difficult year for fund managers, supports such analysis.
However, many IMA equity sectors also underperformed in 2007 and 2008, not years characterised by strength in the fourth quarter.
Relatively high investor cash levels and an absence of clear investment alternatives arguably make the current environment different from 2007-08, but using active manager underperformance to predict a year-end rally has mixed historical support.
This is an abnormal economic cycle that will continue to surprise the market consensus. Given the extent of active funds’ outperformance in the relatively prolonged period of 2012-13, it might be unwise to assume that their period of weakness will abate.
Mark Harris is head of multi-asset at City Financial
