Active fund management or passive - which are the best performing funds?

Commentators are often quick to claim that actively managed fund performance generally fails to justify the higher annual management fees which are charged in comparison to  passive, index-replicating options.

However, the performance of the active fund industry is not as abject as some would have you believe.

At Canaccord Genuity Wealth Management our team only invests in active fund managers following extensive quantitative analysis and qualitative due diligence in order to maximise the probability of our fund selection adding real, long-term value.

In this article, we explain more about what actively managed funds are, why their performance can be misconstrued, and where they tend to outperform.

What is active fund management?

An actively managed fund is one where a fund manager, or team, actively manages a portfolio of investments with the aim of outperforming a relevant benchmark or index.

The decisions about which investments to hold and, just as importantly, which to avoid, are taken after extensive research and the resulting portfolio will be largely dependent on the manager’s philosophical view about which types of stock are most likely to offer this potential for outperformance. Some funds will be targeted towards companies which are expected to deliver strong earnings growth which will be reflected in the outperformance of its stock. Others will instead target companies where it is believed their shares are undervalued by the market, but where this value is expected to be recognised and realised in the future.

What is passive fund management?

By contrast, passive funds simply track a market index or specific market segment, predominantly either an equity or fixed income market. No philosophical views, or subjective decisions are taken. For example, one of the most commonly tracked and quoted equity indices is the FTSE 100 Index – an index of the UK’s 100 largest companies. A FTSE 100 passive fund will maintain exposure to all 100 companies, in exactly the same proportions as their market value. The underlying value of the passive fund will therefore rise and fall in-line with the value of the index.

Partly because of less trading activity, passive funds tend to be cheaper than their actively managed counterparts, where effectively the investor is paying a premium in order to gain access to the fund manager’s ‘skill’ and judgement about which are the best companies to own, and those which should be avoided. However, the trade-off is that passive funds will deliver a return in line with the market, whereas active funds aim, and have the potential, to deliver a return that’s higher than the market.

Active fund manager performance

It's not always the same active fund managers who outperform. Active fund manager A may have outperformed in 2015, but underperformed in 2016. Active fund manager B may have underperformed in 2015 and outperformed in 2016. In a peer group of just these two active fund managers, on average 50% outperformed each year, but neither outperformed in both periods.

This often underlies criticism of the active fund management industry. For example, analysis may reveal that a particular active fund manager made rewarding investment decisions and outperformed in four of the last five calendar years. Because of the one year of underperformance, the fund manager is viewed as having ‘failed’ and seemingly cannot justify the higher management fees charged in comparison to passive vehicles.

This is a facile argument which fails to consider two things. First, no investment should be viewed as a success or failure when measured over just one year. Second, it takes no account of the margin of out or underperformance. If said active fund manager outperforms by 1.5% during each successful year on a net of fees basis, but underperforms by 4% in the more difficult year, over the five-year period as a whole, the fund would still have delivered outperformance of 2%.

What dictates how easy or hard it may be for active fund managers to outperform?

Essentially it boils down to three things – efficiency, market volatility and correlation.

Stock market efficiency is the degree to which stock prices reflect all available, relevant information. The US is generally viewed as being the world’s most efficient stock market and therefore, by definition, the most difficult to outperform as there are fewer inefficiencies on which an active fund manager can capitalise.

The latter two factors are where active fund managers really have a chance to shine as both high market volatility and low correlation provide tailwinds for outperformance.

Greater market volatility allows active fund managers more opportunities to buy stocks when they have fallen significantly and/or sell assets which may have risen meaningfully. In a becalmed sea, the ability to add value by trading shares is limited.

Similarly, if most stock prices are moving together, the potential to add value by identifying ‘good’ companies and avoiding ‘bad’ companies is also limited. The active fund manager does not want the price of everything to move in tandem.

So – should investors pay more attention to actively managed funds?

Active fund managers seem to be judged unfairly in terms of performance which makes it hard for investors to consider their inclusion in investment portfolios. At Canaccord, we see a valuable place for both active and passive funds and we will utilise the best possible combination depending on our objectives and the prevailing market conditions. Both active and passive strategies can, and do, have a role to play. As above, where volatility may be high, and correlation low, it is likely to be better to have the ability to adapt quickly and take advantage of more actively managed opportunities.

Although we adopt an active approach to asset allocation and have proven stock-picking ability, we believe cost-effective access to our investment ideas is a fundamental obligation to our clients. We will therefore always carefully judge the trade-off between the higher costs, and potentially higher returns of active management returns, against the  lower costs of passive management but where there is no potential for outperformance.

Speak to one of our experts

If you would like to find out more about our approach to investing in actively managed or passive funds, of if you would like a conversation about your investments, please get in touch with us or email questions@canaccord.com.

Please remember, if you hold an account with Canaccord, you can check your portfolio value at any time, through Wealth Online or by getting in touch with your Investment Manager.

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Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.

The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.