Tom Bailey: active funds are useful – without being in your portfolio

Our ETFs editor explains how passive fund investors are piggybacking on active fund managers’ time, effort and skill.

An active fund manager makes decisions about the stocks included in their portfolio with the aim of providing a better return than the market. These decisions are carefully considered. Active fund teams spend a lot of money and time on research and analysis. Many very clever people are employed to spend hours doing painstaking research on companies, the economy and wider market.

This research and analysis, they claim, is all worth it as it gives them a superior insight compared with other investors (i.e. the rest of the market) into which stocks will perform better or worse. The active manager claims his or her superior research and analysis results in ‘information asymmetry’. This asymmetry allows them to fill their portfolio with superior stocks and provide superior performance.

In contrast, a passively managed fund simply mirrors an index designed to the reflect the market. There is no active manager and research team poring over the financials of companies or monitoring the macro backdrop – the fund is essentially on autopilot, just buying whatever stocks are in the index it tracks. As has been argued a million times, this is broadly the better way to invest and I, of course, mostly agree.

Why? The active manager and his analysis and research costs money and that cost is shouldered by the investor. To fund the active manager’s team of analysts in their bid to gain ‘information asymmetry’, the investor pays annual management fees, typically ranging from 0.85% to 1%. These increased costs add up over time.

The fees may end up paying for themselves through the outperformance that the research and analysis you, the investor, are paying for. However, the maths is not in your favour here. As the Nobel Prize-winning economist William Sharpe pointed out in his 1991 paper “The Arithmetic of Active Management”, active investing is a zero-sum game. The market is made up of active funds and therefore the average performance of an active fund must be equal to the market’s average return. Add in fees, and the average fund’s performance is the average market return minus the fees. It becomes a negative-sum game. As Sharpe wrote: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs.”

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And if you aren’t convinced by the theoretical arguments, just look at the data. You can find data from all sorts of sources showing that active managers, for the most part, underperform a benchmark index. For illustrative purposes I will use the latest SPIVA scorecards from S&P Dow Jones Indices. As the data from February 2021 shows, in sterling terms, over the past 10 years, 93% of US funds underperformed the S&P 500 and 93% of global fund managers underperformed the S&P Global 1200 index. The rate of underperformance for European, UK and emerging market fund managers is somewhat better, but the majority of fund managers in these regions still underperformed. Of course, some fund managers do outperform, but when investors buy a fund such outperformance cannot be guaranteed in advance.

So, does that mean all the painstaking research going on at fund houses is just a waste of time? Is all the money and time spent trying to gain ‘information asymmetry’ all for nothing?

Well, not quite. While advocates of passive investing may not serve much purpose in your portfolio, active stock-pickers do serve a useful role. In fact, your basket of low-cost index funds would not be possible without them.

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Passive funds are what you can call ‘price takers’. They buy stocks at whatever price the market sets. As we all know, the market is efficient, so we should just accept the price stocks are currently at and know that over time as the economy and company earnings (in aggregate) grow, so too should stock prices (in aggregate).

Meanwhile, active fund managers are what we can call ‘price makers’. Their buying and selling activity is what causes stocks to be priced at what they are. And here is the point: markets are not magically efficient. It is thanks to active manager’s painstaking research about companies that the price of a stock approaches something that reflects all knowable information. It is only because active fund managers have become so good at accurately valuing stocks, with their immense and expensive research capabilities, that the market has become so hard to beat, or ‘efficient’. And, hence, passive investing has become the ‘smart’ option.

So, active management is not a waste of time or energy. Their efforts make markets the efficient information-processing machines they are today. We passive fund investors are piggybacking on this time, effort and skill. Thanks to active managers it makes sense for us to track the global index for a few basis points. There should be no shame in this - we are just doing what is best for our portfolio, which is the end goal of any sensible investor.