It’s understandable why investors who don’t have the inside track on how asset management works tend to find the idea of active management so appealing. After all, people are used to the idea of paying for professional expertise. For example, the more you pay for a lawyer, the better you might reasonably expect that lawyer to be.
Asset management is a very different matter, which is why Carbon’s fourth investment principle, “active buying and selling adds significant cost and erodes value”, was established.
New research from Morningstar (an independent provider of investment research in North America, Europe, Australia and Asia) confirms the problem. Researchers analysed the cost and the performance of US-domiciled mutual funds over the last 20 years and these are the key findings:
- Since the mid-1990s, average excess returns, before costs, delivered by actively-managed mutual funds have fallen in most categories; in other words, the pre-fee pay-off for investing in active funds has shrunk.
- Fees have not fallen as steeply and, thus, around 70% of US equity funds levy expenses that would wipe out their estimated future excess returns.
- Fund overpricing is most widespread among US large-cap funds, but the same problem also applies to international equity funds and fixed income funds.
- Of the funds that charge less than their estimated pre-fee excess returns, many have a margin of error of 0.3% or less before future excess returns are wiped out.
- Over the same 20-year period, the variation of average pre-fee excess returns among funds has narrowed; put another way, before costs, the returns delivered by different funds are much more closely bunched together, and there are fewer obvious winners than there used to be.
Interestingly, Morningstar admits that its figures are conservative; in other words, the real picture for active investors could be even worse. That’s because, in their calculations, the researchers “‘grossed up’ recent excess returns to allow for the possibility that those recent figures were depressed by fleeting factors”.
This, of course, is an extraordinary situation. What Morningstar is effectively saying is that most actively-managed funds are priced to fail and, whether they realise it or not, investors are in most cases paying to have value extracted from their investment strategy rather than added to it.
It’s also worth remembering that the United States has the lowest fees for active management in the world. The value extracted by active managers in the UK, and indeed every other country is, on average, even greater.
So, what are the implications of this research for investors? Morningstar’s Global Director of Manager Research, Jeffrey Ptak said this:
“One inescapable conclusion is that cost will become increasingly important in active-fund selection. Investors must place an even greater premium on low expenses.
“The world is now awash in index funds and Exchange Traded Funds (ETFs), giving investors an easy way to invest in broad swaths of the market at very low cost. Thus, the acid test is no longer active fund A versus active fund B but rather any active fund versus the relevant index fund or ETF for the category concerned.”
There is, of course, an obvious solution to the lack of value delivered by active management, and that is to reduce the cost for investors. Bill McNabb, CEO of Vanguard Asset Management, recently made the same point when he said: “Active management can survive only if it’s offered at much lower expense. Otherwise active management is dead, and rightly so“.
As Morningstar highlighted, fees have come down in the US, but not fast enough. In the rest of the world, the cost of active management has barely fallen at all. The interim report by the Financial Conduct Authority, the UK financial regulator, on its study into competition in asset management, published in November, stated:
“Our analysis shows mainstream actively-managed fund charges have stayed broadly the same for the last 10 years. In contrast, we found that charges for passive funds have fallen over the last five years.”
The active fund management industry has huge resources available for PR and advertising. That, combined with human nature, means there will probably always be a demand for actively-managed funds.
But remember what the academic evidence tells us. Only around 1% of active funds outperform their benchmarks over any meaningful period of time; and although we can all see who the winners have been in the past, spotting long-term outperformers in advance is all but impossible. That makes active management, as it stands, an expensive bet that investors will almost certainly lose.
Only when the cost is very much lower than it is today will it be worth considering including any active funds in a diversified portfolio.