Persistently skilled fund managers are a very rare commodity, difficult to identify in advance and hard to live with over time. Anecdotes and examples of great managers are often used to justify ‘active management’, yet even some of the truly ‘great’ managers have failed to live up to their billing.
With active management, a professional fund manager uses his/her judgment to guess which assets will perform better than average. Paying for this decision-making can involve high costs and high turnover which eat into returns. Index or passive management, on the other hand, is simply tracking an index, market or asset class with significantly lower costs and turnover.
The risks of active funds – as evidenced by the demise of Neil Woodford – are very real and unnecessary. Today, investors have the luxury of selecting well-diversified, low-cost funds that are structured to take rational market risks in the pursuit of sensible market returns and ignoring the blinding light of the brightest ‘star’ manager.
It is human nature to be attracted to talented and seemingly skilful people hoping that a little of their stardust will rub off. That is no less the case when selecting investment funds. The marketing departments of active fund houses and the investment press push mouth-watering sound bites such as: ‘If you had put £10,000 into this fund when it launched it would now be worth £1.55million’ or ‘this is the best performing fund in its sector over the past five years’.
It is understandable to feel tempted. Unfortunately, the academic research and hard data suggest that true, persistent market-beating skill is a very rare commodity, in part because markets work well and the cost hurdles that active managers set themselves, usually absorb any excess return above the market that their skill delivers.
There are some key lessons for investors:
- don’t listen to the siren songs of adverts and article headlines. They are highly selective and usually focused on short-term performance;
- short-term outperformance is a very noisy signal and luck plays a very substantial role in the performance differences between actively-managed funds in the same investment category. Some managers will do well simply by chance, perhaps over a prolonged period. Three per cent of coin flippers will call it right five times in a row. You need around 16 years of data to be able to discern skill from luck with any degree of confidence. Using three to five year fund performance to pick funds is guessing;
- ‘good’ long-term track records may be due to a manager’s style e.g. focusing on smaller value stocks as Anthony Bolton did. Today, it is possible to capture these styles using lower cost, highly-diversified index funds.
- even the few ‘stars’ of the past seem prone to fade or implode. Bad luck, poor judgment, an out-of-favour style, ego and greed all play their part. Over a 15-year period, around 6 in 10 funds cease to exist. Although there may well be some skilled managers to invest with, they are few and far between;
- owning an actively-managed fund is challenging, even if it has a good past track record. Periods of underperformance are an inevitable and unavoidable consequence of owning a fund that tries to beat the market.
In today’s investment space, taking these risks is unnecessary, stressful and the odds of them paying off are low. If you stick to sensible market risks captured by indexed funds, then sensible longer-term returns should follow. To hear how Cavendish can help you achieve your financial objectives, contact one of our adviser team on 020 7636 7006.