Active or passive – which way should investors turn?

This is very welcome as the impact of costs on performance, particularly during periods when equity markets are rising sharply, are perhaps more meaningful than many realise.

Five years ago, we saw the trough in equity markets as policymakers finally got ahead of the curve and the financial crisis bottomed out.

The average fund manager had a poor financial crisis, but since then there has been much to applaud.

In the past five years to April 30 2014, the average UK fund manager in the IMA UK All Companies sector has beaten the FTSE All-Share index by 6 percentage points, and because many exchange traded funds have failed to keep up with the index during this timeframe, the average fund manager has beaten these more handsomely still.

Indeed, anyone trying to replicate the FTSE All-Share index performance by constructing a synthetic FTSE All-Share ETF using the iShares 100 and 250 ETFs as building blocks would have found themselves roughly 3.7 percentage points behind the index in the same time frame. Thus, the average active fund manager has outperformed this synthetic FTSE All-Share ETF by nearly 10 percentage points during the past five years.

Therefore, the rather Orwellian but oft heard mantra that ‘Passives are good; Actives are bad’ has not been borne out over the past five years in this example.

Now it would be easy to claim this is a freak five-year period and the performance of the average active fund manager in the period leading up to April 2009 was so bad as to nullify this finding.

Indeed, over 10 years it is true that the average active UK equity fund manager performed poorly against the FTSE All-Share index – an IMA UK All Companies sector average of -5.9 per cent.

However, based on the same back of the envelope calculation, a synthetic iShares FTSE All-Share ETF would have underperformed the average active UK fund manager by a further 3.5 per cent over the same time period.

The underlying data shows that in the 10 years to April 30 2014, the iShares FTSE 100 ETF is 8.7 percentage points behind the FTSE 100 index, while the iShares FTSE 250 ETF is behind the FTSE 250 index by 15.2 percentage points, according to the iShares website.

Now, iShares has been used as an example purely because the data was readily available, and I am certainly not ideologically opposed to index tracking ETFs.

Indeed, we believe ETFs are a useful investment tool to effect tactical asset allocation switches.

Furthermore, it would be right to question whether the average active UK fund manager will be able to continue to outperform the FTSE All-Share index.

On our numbers, the past five-year period to the end of April is the strongest five-year period of performance for the average active UK equity fund manager in any ‘end of April’ five-year rolling period for more than 20 years.

It could, therefore, be argued that a reversion to the mean is overdue.

While I do not believe this time has come yet, the recent brutal rotation out of FTSE 250 stocks into their larger-cap brethren is surely a warning sign that we may not be far from that turning point.

The other key point is that the underperformance of the ETFs versus their respective benchmarks has been exacerbated by the strength in equity markets during these timeframes and shows the drag costs have in strongly rising markets.

With the dramatic fall in ETF management charges, such a performance drag will be much diminished going forward.

Hector Kilpatrick is chief investment officer at Cornelian Asset Managers