Recent headlines stemming from an S&P Dow Jones report on active fund underperformance in 2016 will understandably raise questions from clients, says Darius McDermott, as he highlights some key points you could discuss
If you subscribe to the same plethora of financial news emails that I do, chances are you have of late seen more than a few headlines in your inbox along the lines of "87% of active UK equity funds underperformed in 2016". This was a significant change on 2015, when around 78% of funds outperformed, according to the report on which all the headlines were based.
The stats come from the S&P Dow Jones Indices' scorecard, which compares funds in major sectors to the markets in which they operate. Being an ardent believer and investor in active management, personally, I strongly support research on fund performance. It plays an important role in maintaining standards and ensuring managers act in investors' best interests.
Like any data, though, it is important to view results in context and, crucially, to help our clients do the same. The stories stemming from this S&P Dow Jones report will understandably raise questions. So what are some of the key points you could discuss with clients?
Active versus passive - different goals
Put simply, active management is about trying to beat the market. If you are buying a passive fund, you never give yourself that chance. Active managers pursue their goal by deliberately differentiating their funds from the market - for example, by investing with a style bias, focusing on mid or small caps, holding just a handful of high-conviction companies or looking only for specific stock characteristics.
Choosing active therefore has two major impacts - returns may differ from the market and returns may depend on manager skill. I know this all seems obvious to us but I think many clients are not necessarily clear on the two different approaches and what they should expect from each.
Downside protection too
Active investing is not just about the potential upside though, as I have said before. Passive funds' surge in popularity over the past few years has coincided with an extended bull run. Everyone wants to buy into something when the price is rising. US and UK markets have been rising steadily and investors who bought trackers a few years ago may have been well rewarded.
But what happens if we hit a rough patch? Brexit negotiations are a big unknown in the UK and Europe while President Trump does not seem to be getting very far with his growth-boosting reforms on the other side of the Atlantic. Arguably, markets are pricing in positive developments that may not in fact materialise.
I am particularly concerned about this in the US, where valuations are stretched no matter which way you look at the metrics. If things go pear-shaped, I would rather be in a fund that has invested selectively, with an experienced manager who has already steered investors through a few ups and downs.
Investing with a longer-term view
I have already mentioned that active funds' returns will likely differ from the market from one year to the next - but what matters more is that they outpace their benchmarks steadily over time. Most active funds aim to achieve alpha over the medium to long term - and 2016 provides a good example of why.
That 87% of active UK equity funds underperformed last year is probably not surprising, given the huge fall in sterling that drove large caps to trade around record highs. Many of the best active managers do not invest heavily in this area of the market.
When such a significant macroeconomic event temporarily overrides other return drivers, it can mean active funds struggle. But I would not want to see these managers sacrifice their long-term strategy for the sake of short-term gains. Remember, you may have chosen their fund especially to gain access to that strategy.
I would also emphasise that active fund holders were still well into positive territory in 2016. The average IA UK All Companies fund returned 10.8% after fees, while the FTSE All-Share finished the year up 16.75%. And, of course, 13% of active UK equity funds did still beat the market in 2016. Investors in a fund such as R&M UK Equity Long-Term Recovery or Jupiter UK Special Situations would have seen their savings grow 28% and 22.4% respectively.
Good and bad - like everything else
Which brings me to a final point worth making, which is that there are thousands of funds available to UK investors - across all sectors - and, like everything else, you will find good and bad options. Looking at longer time frames, the S&P Dow Jones scorecard said 50% of active UK equity funds underperformed over five years and 74% over 10 years.
Without a doubt, these numbers indicate many active funds still need to be held to account and I make no excuses for consistently underperforming managers. But the results also affirm the philosophy at the heart of the FundCalibre ratings business, which is that only a small percentage of funds are truly elite.
I have written before about the role research agencies and advisers have to play in doing due diligence. Those managers who receive our Elite Rating have long-term track records of alpha generation and I will always believe in the value we can add by highlighting these opportunities to investors.
Darius McDermott is managing director of FundCalibre
The chairman isn’t answering his email
Reforms not enough
An economic cocktail
To encourage consumers to shop around
Will report to Pat Shea