Why active funds underperformed their benchmarks in 2023

But this investment environment presents opportunities in the small-cap space, investment experts note.

The report, published earlier this month by the LSEG Lipper fund research house, also found that the overall average relative underperformance of environmental, social and governance-related equity funds versus their fund manager benchmarks (-1.93 per cent) was higher than for their conventional peers (-1.08 per cent).

Noting that 2023 was a year marked by a lot of geopolitical tensions around the globe, the paper said this showed that democratic states were more vulnerable than once thought – a situation it is fair to say has continued into 2024.

There was also a raft of economic factors that burdened the expectations of investors: China’s failure to meet the growth expectations of investors after the end of its zero-Covid strategy; the meltdown in the bond markets at the end of 2022; high inflation and interest rates; and bank collapses. 

Author of the report Detlef Glow, head of EMEA research at LSEG Lipper, said: “[Last year] can be seen as a year in which active asset managers had the chance to deliver a high value-added compared to passive strategies by using cash as a risk buffer in times of market turmoil and investing in high beta stocks in an upswing of the market. In general, the results of this study show that active equity fund managers did not achieve this goal.”

Magnificent stocks

According to Darius McDermott, managing director of Chelsea Financial Services, the recent dominance of mega-caps, particularly the 'magnificent seven' (Alphabet; Amazon; Apple; Meta; Microsoft; Nvidia; and Tesla), made underperformance by active funds almost inevitable in the past year. 

“It is always going to be difficult for managers to outperform when large constituents in the benchmark are doing so well,” McDermott adds.

Ben Yearsley, director at Fairview Investing, agrees: “It was no surprise that so many actively managed funds didn’t beat their benchmark when so few stocks (seven) drove the market.”

But McDermott cautions that a one-year performance data is not a long enough to judge any investment strategy.

Nick Wood, head of fund research at Quilter Cheviot, adds: "It is a very short time frame. Ultimately last year was about one thing if you were a global manager: the magnificent seven stocks. These seven stocks led the market but also made up nearly 20 per cent of the MSCI World index at the end of the year.

"To outperform investors likely had to be willing to invest in growth stocks or flexible enough to be able to tilt the portfolio towards them. That also required a high weight in the US, something that will not have been possible from a risk perspective for many funds.

"With the boom in artificial intelligence, the story of 2023 quickly become one of the US being the most concentrated market in terms of where index performance was derived from and the subsequent impact this had on the investing landscape."

High fees

Another driver of the underperformance of active funds, according to McDermott, is fees: “All funds have years where they underperform, however, the longer-term evidence is undeniable that active managers have continued to struggle. The main reason for this underperformance is because active funds charge higher fees.”

Referencing the methodology of the data gathering, Glow said that for the evaluation of the relative performance of actively managed funds versus an index/benchmark, one needed to take fees and expenses into account since indices and benchmarks are calculated without taking any fees or expenses into consideration. 

The average total expense ratio – a measure of the total costs associated with managing and operating an investment fund, such as a mutual fund – of all equity funds covered by this report was 1.545 per cent.

These costs typically include management fees and additional expenses such as trading fees, legal fees, auditor fees, and other operational expenses.

I think it’s good to keep to conventional benchmarks. Made up benchmarks are generally not trusted.Ben Yearsley, Fairview Investing

Thanks to lower barriers to entry, McDermott says the active fund market has become increasingly competitive in recent years, pressuring fund charges to come down across the board. 

“This is great news for investors, who can now access many exceptional active managers at better value for money,” he adds.

“While it may still take a few years before we hit 'peak passive', as long as active fund fees continue to fall we are confident these strategies are set to see a strong resurgence in the future.”

Flexibility needed

McDermott’s view is that being rigidly pro-active or pro-passive is a bad idea: “Fund selectors must be pragmatic and evolve with the times, and these different products are all tools at our disposal. 

“For example, we are currently excited about the opportunity in the active small-cap fund space. Firstly, managers typically have a much higher chance of adding alpha due to the lack of research coverage in the small-cap universe.

"Secondly, small caps broadly have become massively undervalued compared to the wider market – with the exception of Asia – over the past few years, which has created attractive opportunities for stock-pickers.”

In the paper, Glow acknowledged that since this study was conducted over a limited time period, the results had only a limited prediction power for the long-term results of active managers. But he added that studies over different time periods had shown similar patterns. 

Benchmarking

When it comes to the performance of ESG funds, the report said one reason for the low percentage of outperforming ESG-related funds was that a number of them were using conventional benchmarks to showcase their ability to beat the respective market – an approach taken as critics raised concerns about a possible underperformance of ESG-related products compared to their conventional peers caused by their exclusion criteria.

Yearsley says ESG funds tend to be more growth-focused and although 2023 was more nuanced than, say, 2022, value was more in vogue than growth. This led to ESG underperformance.

He adds: “I think it’s good to keep to conventional benchmarks. Made up benchmarks are generally not trusted. ESG funds are clearly not going to outperform conventional funds every year, so why try and trick investors into thinking they can?”

McDermott says if ESG funds can claim their strategies should lead to better investment returns – rather than just a better planet – it makes sense to judge them against conventional benchmarks. 

However, he adds that comparisons against multiple benchmarks may provide a more comprehensive picture of their performance and impact.

McDermott says: “Performance has been disappointing in the ESG-focused space for several years and there is little or no evidence that they are achieving the positive effects on the planet they promise. In fact, exclusionary approaches may even be harmful.

“ESG strategies need to show they are not just a marketing gimmick and can deliver real substance. We believe that there will be a growing distinction within the ESG space between the impact strategies that are actively innovating and solving problems and the strategies that are just perpetuating the status quo.”

Concluding his report, Glow said the Achilles heel of the asset management industry is the way the risk management process works, in that most asset managers measure the risk of their portfolios relative to their benchmark or index. 

You need to be aware of what the broader market is doing with regards to return drivers in order to manage your own risk.Nick Wood, Quilter Cheviot

As a consequence, the asset allocation decisions of portfolio managers are restricted by the weighting of the stock or sector within the respective benchmark.

This, the report concluded, means that a portfolio manager might not be able to avoid an investment in a stock or sector that he/she expects to underperform. 

Additionally, a high number of asset managers do evaluate the performance of the fund relative to its benchmark, resulting in the fact that a negative performance of the fund is seen as a success as long as the negative returns are better than those of the respective index or benchmark. 

Glow added: “Conversely, most investors see negative returns in general as bad results. Therefore, it would make sense that asset managers would implement some risk measures with regard to the absolute performance of their funds to align the interest of investors with the targets of the portfolio managers.

“Taking the absolute performance into consideration would also help to increase the resilience of a fund since the portfolio manager could use cash as a risk buffer.”

McDermott says he agrees with the first part of this conclusion, but not with the second part on measuring performance on an absolute basis.

He explains that a desire by active managers to retain assets can often encourage benchmark hugging, which sometimes hurts performance.

This is why metrics like active share, which indicate how much a portfolio deviates from its benchmark, are very important. However, for McDermott, by far the biggest Achilles heel of the asset management industry is higher fees.

He adds: “I am afraid the second part of the conclusion does not make any sense. Funds should be judged on a relative basis to their benchmark. Markets are inherently volatile, meaning negative returns are inevitable in some periods, however, for this very same reason there is a higher expected return for holding equities. Investors should be aware of these factors and plan accordingly.

“It does not make sense to measure performance on an absolute basis as allocating to cash is not the fund manager’s job – unless they have an exceptionally strong conviction that the market is overvalued. This type of asset allocation decision should be made by the investor or their adviser."

Likewise, Quilter Cheviot's Wood says whether a fund has an index or not, intelligent fund selectors will continue to assess them against a relevant comparable index, such as the MSCI World index if that is appropriate.

There is room for many types of fund in both categories and as long as you know what you’re buying does it matter?Ben Yearsley, Fairview Investing

"You need to be aware of what the broader market is doing with regards to return drivers in order to both manage your own risk, but to identify new and potentially exciting ideas," he adds.

"Equally, they should already be considering the impact of any strong style tilt on expectations. I suspect if absolute return targets were instituted at the start of last year, funds would actually have done worse, with managers less likely to invest so much in the US or the seven largest index names.

"Longer term it may well provide better performance if those largest names lag, but given the report discusses 2023, this measure is likely to have the opposite effect over that period."

Meanwhile, Yearsley says he “does not mind” cash being used if managers think markets will fall.

“Very few do though, as they think they shouldn’t be market timers,” he adds. “I don’t really care whether a fund compares itself to a benchmark or not, or manages it relative to the benchmark. There is room for many types of fund in both categories and as long as you know what you’re buying does it matter?”

Ima Jackson-Obot is deputy features editor of FTAdviser