American author and publisher William Feather once noted, “One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute”.
"The passive fund was an extraordinary innovation"
Although the investment industry would have you think otherwise, the chances of all funds in a particular sector outperforming their benchmark over a meaningful period are practically zero. If 100 funds pick stocks at random, one should expect 50 of them to outperform. After fund costs, the number tends to be around 1/3.
Moreover, the reality bears this out. Headlines such as “99% of actively managed U.S. equity funds underperform” or “87% of active UK equity funds underperformed in 2016” are commonplace.
Underperformance of the average fund is nothing new. John G. “Jack” MacDonald, the highly respected Stanford Professor of Finance, noted in a 1974 paper that during the 1960s, approximately 1/3 of mutual funds underperformed the stock market index.
However, it took the creation of the first passive fund in 1975 - the First Index Investment Trust, later known as the Vanguard [S&P] 500 Index - for investors in so-called mutual funds to realise many of them had a better option.
Prior to 1975, the S&P 500 index was not ‘investable’ as it is now, so few, if anyone, equated the average fund’s underperformance to a flawed industry. Even Fidelity Investments chairman Edward Johnson was quoted as saying that he “[couldn’t] believe the great mass of investors are going to be satisfied with receiving just average returns”, as if they were already doing better than average which, as noted, was clearly not the case.
Nowadays, there are many millions of investors in passive funds who are not only satisfied with average returns, but downright delighted. The passive fund was an extraordinary innovation, perhaps one of the few of which the investment industry can be genuinely proud - there are, of course, many others that should make it feel ashamed.
However, what about those who continue to invest in actively managed funds? How are they feeling? On the basis of the aforementioned headlines, many of them must be feeling pretty miserable. What could be done, other than the obvious, to make them feel less miserable?
Apart from the ubiquitous “investments can go up as well as down”, there is little that prepares fund investors for what might lie ahead. Actively managed funds are not like cars or TVs that can be repaired when they go wrong. Underperformance of an active fund can often represent a permanent loss of capital in relation to its passive equivalent, particularly if the underperformance is crystallised through a sale. Funds going wrong is one thing. The absence of a repair shop is something else altogether.
As the chief investment officer of a company that runs actively managed funds, I try hard to prepare our investors for what might lie ahead. I tell them that fund performance is a zero-sum game and thus that our doing well has always to be at another manager’s expense. I tell them that our funds will underperform in the short term from time to time, but that this is the cost of good long-term performance. I tell them that our funds have low turnover, and thus a long investment time horizon, because investments over the short term are unpredictable. I tell them that funds must have the scope to produce outperformance well in excess of fund costs, which means being very high conviction. Finally, I tell them that when we buy, we believe we are being astute, but also that could that we could be wrong.
These are all home truths that we believe we have a duty to tell our investors. While it would be hard for the regulator to package them into some sort of broader warning, the industry and its participants could certainly do better.
Published in What Investment
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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