If you were a Martian coming to Earth for the first time, you might read the investment press and social media and assume actively managed funds are a persecuted minority.
Certainly 2015 was a good year for passive vehicles. Around 40 per cent of the £315bn of net inflows went into index products and exchange-traded funds in Europe last year. But the average for passive flows into the region since 2004 has varied from year to year and only averages 10 per cent.
The cost-disclosure and closet-tracking ‘scandals’ that burden the active industry are overstated. Research published by Thomson Reuters Lipper found just 2 per cent of funds in popular Investment Association (IA) classifications have lower rolling tracking errors for 2015 than similarly classified index products.
The decision to invest in active or passive vehicles is purely philosophical. If you believe markets are fully efficient, passive is for you. If you believe markets are inefficient, then an active manager will give you the chance to generate excess market returns.
This trade-off can be considerable. In the IA UK All Companies sector for the year ended December 31 2015, the three-year opportunity cost of investing in the best-performing, broad-based tracker fund instead of the best active product was a huge 64 per cent, while in the IA Europe ex UK sector over the same period it was at 46 per cent.
While these excess returns are material, they provide only a snapshot rather than evidence of consistency. Contrary to the well-known disclaimer, past performance is the only indicator of future performance we have, and consistent active fund outperformers can be discovered.
Using a risk-adjusted return metric – such as the 12-month Jensen’s alpha rolling monthly over five years – can reveal a multitude of opportunities.
By looking at all funds in the IA sectors for the first four months of the year, we can use the average of these rolling monthly observations to identify which products are consistently beating their benchmarks.
In the IA UK All Companies sector there are 235 vehicles with the requisite performance history and a specified benchmark. Some 74 per cent of these funds have an average rolling Jensen’s alpha greater than zero, meaning they are outperforming the market on a risk-adjusted basis. The average for the sector is 0.20.
In the IA Europe ex UK sector, 80 per cent of the eligible funds are outperforming, with the overall average for the group at 0.16. However, the highly efficient US market appears to pose some problems. Just 15 per cent of the eligible funds have a positive Jensen’s alpha, and the sector average is -0.13.
There is clearly evidence that active funds – and in some sectors a considerable majority of them – are able to consistently beat their indices. Some sectors fare better than others. The UK Smaller Companies sector, with a 0.61 average, is ranked highest. At the other end the IA Global, Specialist, Targeted Absolute Return and North America sectors are all negative.