For many years, there has been a big discussion in the world of finance as to whether index trackers are a better way to invest than managed funds. It’s sometimes called the Active vs. Passive debate. The evidence is fairly clear cut, however, and it shows that index trackers beat the vast majority of managed investment funds over the long term.
It’s certainly true that the best managed funds will do better than an index tracker, even over long periods. However, the difficulty is identifying which ones are the ‘best’.
You’ve probably seen the ubiquitous disclaimer that “Past performance is no guarantee of future results” — it’s there for a good reason!
The evidence on the performance of managed investment funds
One of the most famous pieces of research in this area is called S&P Indices Versus Active Funds (SPIVA). It looks at funds across the US, Europe, and many other major markets.
Each year, the SPIVA reports show that somewhere in the region of 75% to 85% of funds fail to beat their benchmarks over 10-year periods, when you adjust for funds that didn’t survive for the whole decade.
The precise numbers vary when you drill down into specific fund sectors, but the overall message is always very consistent across all regions and company sizes.
An index tracker will tend to trail its benchmark by a small amount because of its running costs, but the message from SPIVA – and all the other research carried out in this area in the last few decades – is clear: the average index tracker will tend to outperform the average managed investment fund.
Why do index trackers tend to beat managed investment funds?
Taken together, managed funds essentially are the market. This means that collectively they hold their investments in pretty much the same proportion as an index tracker does.
Before taking costs into account therefore, you’d expect a managed fund and an index tracker to produce the same sort of return.
When you take costs into account, however, there are two key differences between index trackers and managed funds. Firstly, charges for managed funds tend to be a lot higher than index trackers. A typical managed fund charges around 1% a year, whereas the average index tracker is probably nearer 0.2% This difference may sound small, but it compounds each year and gives index trackers a huge advantage over the long term.
The second difference is that managed funds tend to buy and sell their underlying investments more frequently. It’s reckoned that the typical UK fund buys and sells around half of its holdings each year — so its portfolio turnover, as it is called, is around 50%. The dealing costs and stamp duty tax associated with this give managed funds an additional handicap to overcome. Index trackers tend to have an annual portfolio turnover of less than 20%.
Can you find just the best managed funds?
Unfortunately, identifying what the best managed funds are in advance is not easy. It’s simple to look at past performance tables and pick those with the highest returns. But there’s no guarantee those returns can be repeated.
Perhaps the fund manager who delivered those returns has retired and their replacement isn’t quite as sharp.
Perhaps the majority of the gains were delivered when the fund was relatively small and nimble. Now it’s larger, the fund manager finds it harder to generate the same sort of performance.
Perhaps the fund was concentrated in a fashionable sector that has now fallen from favour.
In fact, the managed investment funds that do the best over short periods tend to be those in highly volatile areas, and picking these can be a very dangerous strategy. Check out their long-term returns and the picture may be far less rosy.
That said, there are a few factors that seem to improve the chance of the fund being a better performer.
Lower costs seem to help as do things like more concentrated portfolios (i.e. 30 investments or fewer) and less frequent buying and selling within the fund (lower portfolio turnover).
SPIVA also reckons larger funds and those that invest in their own domestic market rather than in foreign markets tend to do a little better.
There’s no guarantee following these guidelines will ensure you pick the best managed funds, but they may tilt the odds in your favour.
How to buy funds
It’s become a lot simpler to buy funds in recent years thanks to the rise of investing platforms. They allow you to buy and sell funds in much the same way as you would buy or sell a quoted company.
Typically, you would log into your account and then search for the fund you want and put in a buy order. Most funds are only priced and traded once a day, so your order is grouped up with everyone else looking to trade that fund and processed in a single batch.
Some platforms try to highlight a short list of what they believe to be the best managed funds. However, this practice has come under a lot of scrutiny in recent years and many people question its usefulness.
How to sell funds
Selling a managed fund is just as simple these days as buying one. You log into your investment platform and just decide what to sell and in what quantity.
As with any fund purchase, as a fund is only priced and traded once a day, it may take a short time before the sale proceeds are in your account.
Most platforms let you enter sell and buy transactions at the same time, so it’s very easy to transfer your money to another fund without any undue delay, if that’s what you’d like to do.
The best managed funds can beat the market but the vast majority of managed funds do worse in the long term. The main reason is the fees charged by active managers, which are typically much higher than you pay with an index tracker. Managed funds also tend to buy and sell their investments on a more frequent basis and this incurs additional costs that reduce their returns.
It’s difficult to know what are going to be the best managed funds to own. Investment trends go in and out of fashion so what’s done well in the past may not do so well in the future. However, some research suggests that funds with low charges, a relatively concentrated portfolio with perhaps 30 holdings or less, and that doesn’t tend to churn (i.e. buy and sell) its investments too frequently should have a better chance of outperforming the market.
This will change depending over what time period you are looking at and whether by ‘best’ you are looking purely at returns or a combination of both a high return and low price volatility (sometimes called risk-adjusted return).
Over the last 10 years or so, investing themes like ‘growth’ and ‘quality’ have been in favour so funds available to UK investors run by the likes of Baillie Gifford, Fundsmith, and Lindsell Train in particular have become very popular. Funds that specialise in the US market and the technology and healthcare sectors have also done very well. Whether this will be the case over the next 10 years is, unfortunately, impossible to know!
It varies from sector to sector but you’d typically expect a group of managed funds to underperform the market they invest in by perhaps one to two percentage points a year, given that’s the typical cost of a managed investment fund once you count up all the fees and trading charges incurred.
However, some sectors that tend to be less well researched by brokers and analysts, like smaller companies, seem to be more suited to an active approach and sometimes perform a little better on average.