Theoretically, active funds are a high-risk, high-reward approach to investment.
Rather than following the market, active fund managers use careful stock selection to beat the returns of their passive competitors. In exchange, investors accept higher costs for this potential to outperform the benchmark over a full market cycle.
However, investors banking on active funds in recent years may have been disappointed. Last year witnessed the worst performance for active equity managers in a decade, with an average information ratio of -0.52 across the major Investment Association sectors.
Indeed, according to the most recent Manager vs Machine report from AJ Bell, just 14% of IA Global funds beat their passive rivals over the past five years.
The picture does not look much better on a regional basis, with research from SPIVA finding that just 23.7% of US funds beat the S&P 500 over the same time frame.
As a result, Daniel Coatsworth, investment analyst at AJ Bell, explained that investors have pivoted towards passives and become “fed up” with active managers. “Investors are sick of managers failing to deliver consistent outperformance, and they are asking themselves, why would I need to beat the market when I could track it?” he said.
While this is an understandable trend, it is a dangerous one, said Simon Edelsten, manager of Goshawk Global and Goshawk Global Balanced and a former fund manager at Artemis. He thinks many of the investors gravitating towards index trackers misunderstand the aims of both passive and active funds.
Despite their reputation as low-cost, low-risk approaches to investing, “passive funds are not low-risk portfolios”, he said. This is because global equity indices have become over-concentrated and unbalanced.
The Magnificent Seven (Nvidia, Microsoft, Apple, Tesla, Amazon, Alphabet and Meta) now represent more than 25% of global indices on the back of strong performance in recent years.
“It is an unusual period for markets. The last time there was such a high dominance and correlation between one group of stocks was the so-called TMT bubble in 2000,” Edelsten said.
Fund managers’ fear of missing out and obsession with outperformance meant they hesitated to sell their highly correlated technology, media or telecom stocks, so when the TMT bubble popped, many active funds went with it.
This is the big risk currently facing the Magnificent Seven, he argued. Not owning these stocks has made outperforming the index an uphill battle for most active managers, so many active funds have opted to hold as many as possible to try and keep up with their passive counterparts.
However, because they are all technology stocks, they are highly correlated; they rise and fall together.
After the TMT bubble burst, the active funds which thrived were those that prioritised capital preservation, he recalled.
As a result, the way to run a successful active fund is to “be sensible”, rather than fruitlessly trying to beat passive counterparts. Active funds should have a “common-sense approach” to investing and spread their money across a range of different growth companies, rather than chasing the benchmark, he said.
“For example, in our fund, we are selling technology stocks and buying mining stocks or Japanese banks, which is so far away from that part of the market. As a result, we do not beat the market when technology stocks are on the rise, but it means we outperform by 50% on the way down,” he explained.
Periods of outperformance for an active fund should be short but dramatic, he said, arguing that the role of active funds is not to outperform by constantly beating the benchmark, but to protect investors from market downturns. Ironically, this means “active fund managers must underperform if they want to outperform”.
The value of this sensible approach to investment “has been demonstrated in the past couple of months” when the leading tech stocks have been experiencing corrections in their valuations. “Active fund management comes into its own at times like this”, he said, but investors need to stick to their knitting and “not worry about performance”.
“I am not saying you should have nothing in tech. You should just have a sensible amount, which is rather less than what the index has currently”.
He concluded: “There are managers and fund houses who try to run active funds to beat passive in bull markets, but it cannot be done. The real point of active funds is to be sensible when markets look over-pumped and to protect capital. That is their value.”