The argument runs that, in markets where there’s fewer participants (often referred to as ‘inefficient markets’), active managers can use their skill to turn these inefficiencies into alpha. However, our research shows that it’s not that simple.
One problem is that the theory of the zero-sum game applies to all markets, whether they are ‘efficient’ or ‘inefficient’. The zero-sum game states that the index return in any market is simply the average of all the underlying securities in that market. So, by definition, for every pound invested that outperforms, there must be another pound that underperforms.
But that’s before costs. After costs, less than half of the invested pounds outperform – and, the higher the costs, the lower the proportion of pounds that outperform. Another way of thinking of it is that, for every pound paid to an active manager in fees, that manager has to generate more than a pound’s worth of alpha to make active management worthwhile.
Research shows that active managers find it hard to overcome this cost in all markets. In fact, with the average active OCF standing at 1.45 per cent in emerging markets (typical of an ‘inefficient’ market) versus 0.95 per cent in UK equities, the cost hurdle is often higher in exactly the markets where investors traditionally think that active managers have an advantage.
Index funds, meanwhile, typically have much lower fees: for the two sectors mentioned above, the average passive OCFs are 0.37 per cent and 0.58 per cent respectively. Passive funds also have a lower dispersion of returns, which makes it less likely that advisers will have to explain deviations in performance.
Let’s look at real data. In the 15 years leading up to December 2013, the majority of actively managed funds have underperformed their prospectus benchmark – in efficient and less efficient markets alike.
The blue bars in the chart show just the funds that lasted the entire period, while the second grey bar accounts for those funds that were closed or merged during the period. Our research shows that most of these ‘dead’ funds had previously been underperformers. It’s important to include them in the analysis because, without the benefit of hindsight, lots of investors will have chosen them at the start of the period, so they’re an important part of the overall investor experience. So, faced with this uncertainty, what should investors and their advisers do?
Rather than tying their value proposition to the success or otherwise of an active manager, advisers are increasingly focusing on the things they can control. So they are demonstrating their value by helping their clients define their investment goals; establish a suitable asset allocation; minimise costs and make sure they maintain long-term investment discipline.
Nick Blake is head of UK retail at Vanguard