Why active funds will struggle to beat passive in 2023

Long-term statistics show that more active funds fail than succeed at beating the wider market, which is why some investors prefer to opt for the simpler approach of “buying the market” through an index fund or exchange-traded fund (ETF).

However, proponents of active management argue that they are not looking for the average fund or the average return, and that identifying the cream of the crop among fund managers can result in notable outperformance over a stock market. 

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While there’s plenty of debate over the merits and flaws of active and passive funds, one thing that both camps agree on is that there are certain areas where active funds struggle to gain an edge (such as US large-cap strategies), and some areas that passive is poorly suited to (such as illiquid and real assets).

Why active funds have been struggling to beat passive 

The higher fees charged by active funds compared to index funds or ETFs is a hurdle for many investors. The typical active fund investing in developed market equities, such as UK or US shares, has a yearly fee of around 0.85% to 1%. In contrast, various index funds or ETFs providing exposure to those regions charge 0.1% or less. The gap between the two charges needs to be surpassed by active fund managers to outperform passive.

Another hurdle for active funds is what’s driving the overall performance of the index they are competing against. If a certain sector is enjoying a purple patch of form, this makes it more challenging for fund managers to outperform. Whereas, if it is a broader set of companies and sectors that are performing well, it is not so much of an uphill task.  

This has certainly been the case for US and global funds over the past five years or so, due to the dominance of a small number of the largest US technology companies.

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Last year was an exception to the rule, as technology firms saw their high valuations cool in response to interest rate rises, and share prices fell sharply.

However, year-to-date in 2023 technology stocks are back at the height of fashion. This is primarily driven by excitement around the potential of artificial intelligence (AI), which is predicted to disrupt various industries. 

The so-called Magnificent Seven, Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Meta Platforms (NASDAQ:META), Tesla (NASDAQ:TSLA), Alphabet Inc Class A (NASDAQ:GOOGL) and NVIDIA (NASDAQ:NVDA), have seen their share prices surge so far in 2023. Nvidia is viewed as the star stock to play the AI theme as it manufactures the computer chips that leading AI systems are developed and implemented on.

The dominance of the Magnificent Seven

As a result of share prices sizzling, those seven stocks have become an even more influential part of US and global indices, which index funds and ETFs have exposure to. For some indices, such as the Nasdaq-100 index, this led to an over-concentration that needed addressing to keep risk in check. Last month, a rare “special rebalance” took place, which cut the index’s top 10 holdings from 55% to 43%.

Quilter Investors, a wealth manager, points out that the index domination of US technology stocks is close to the highest its ever been. For the MSCI USA Index, the Magnificent Seven had a collective weighting of 25% in mid-July.

Those same seven stocks now account for around 30% of the S&P 500 index. For the MSCI World index, the weighting is less, but still significant, at 17.4%.

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A consequence for active funds of those indices having a higher exposure to the seven big tech stocks is that it is harder to outperform. This is due to most active funds holding less than the index in those seven stocks.

Fund rules aim to avoid over-concentration to keep a lid on risk. The European Union’s UCITS rules, a regulatory framework for funds sold to investors in Europe, stipulate that holdings accounting for more than 5% of a fund’s portfolio cannot collectively account for more than 40% of the fund's overall holdings. UK fund rules prohibit an individual holding exceeding 10% of a fund’s total assets, while investment trusts do not have a 10% limit.

These rules help to ensure that active funds are appropriately diversified. While a small number of funds, such as those managed by Nick Train and Terry Smith, adopt a concentrated approach of 25 to 30 stocks, most funds typically hold 40 to 80 stocks, with holdings spread across several sectors. Some, however, hold hundreds of stocks, such as F&C Investment Trust (LSE:FCIT).  

Active funds typically hold less in the largest companies

In their drive to look different to the index, in an attempt to outperform it, most active funds cast their nets wider. Some, for example, search for “tomorrow’s winners”. As a result, many funds have less exposure than the index to the largest companies and greater exposure to mid- and small-sized companies.

And as most fund managers are stock pickers – choosing shares based on certain attributes and fundamentals – it is unlikely that all seven stocks would be held. It is more likely that a couple of stocks, those deemed the highest-conviction holdings, would be selected.

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Another factor is valuations. While a compelling argument could be made for any of the Magnificent Seven, the strong share price gains year-to-date have pushed valuations up to high levels. As Quilter Investors says: “Profitability forecasts for the Magnificent Seven vary, but some have very high valuations to meet.”

High valuations come at a price

History suggests that high valuations do not last indefinitely. Research from WisdomTree illustrates this point. It examined the performance of 99 US stocks that had the highest price-to-sales (P/S) ratio in the S&P 500 index since 1960. The firm notes that this valuation measure, which is based on the trailing 12 months of sales, is a useful way to size up tech shares “as it offers a way to evaluate companies that may not yet be profitable but are generating sales - a common scenario among new and innovative firms”. It adds that “for many in the tech sector today, this ratio has soared to unprecedented levels”. Currently, it is Nvidia that has the highest P/S ratio.

WisdomTree crunched the numbers to see how those 99 stocks with the highest P/S ratio subsequently fared to see if their outperformance of the market continued. The first year on from taking the top spot, these companies continued outperforming, on average beating the S&P 500 by almost 1.5%.

However, their momentum faltered in the years that followed. WisdomTree found that their average annual return declined to -4.4% over three years, and the five-year average annual return fell further to -1.5%.

The firm says: “Notably, the markets were annualising over 9% over those next three to five years, so their underperformance versus the market was more than double digits. When we take the entire history of these stocks, their average return still falls short of the market by over 12% a year.”

How have global and US funds fared so far in 2023?

The global fund sector accommodates 547 funds, both active and passive. Year-to-date the best performer is L&G Artificial Intelligence ETF, up 28.7%.

However, it is the MSCI World index that is the best measure for pitting active fund performance against passive. Year-to-date, the HSBC MSCI World ETF is up 10.8%. This is ahead of the average fund return of 5.9%.

Among the 249 funds in the North America sector, the top three performers year-to-date are all passive, namely the Invesco NASDAQ-100 ESG ETF, the Invesco EQQQ NASDAQ-100 ETF and the iShares NASDAQ 100 ETF. The respective returns are 35.6%, 34.7% and 34.7%.

So far in 2023, the best-performing passive funds following the ups and downs of the S&P 500 index are the iShares Core S&P 500 ETF USD Dist (LSE:IDUS) and the Vanguard S&P 500 UCITS ETF GBP (LSE:VUSA), both up 12.9%. This is ahead of the average US fund return of 9.0%.