Big B

Passive vs. Active—the View from Across the Pond

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Big B

While perusing the Daily Telegraph, one of our Wealth Advisors came across this article that highlights the bloody awful results delivered by active managers in the U.K. Reporter Richard Evans cites Professor David Blake of the Cass Business School of City University in London, one of the authors of this study  of 516 funds between 1998 and 2008 which found that:

  • The average equity mutual fund manager is unable to deliver outperformance from stock selection or market timing, once allowance is made for fund manager fees and for a set of common risk factors that are known to influence returns (market, size, value, and momentum). The average fund returned 1.4% less than the market after fees.
  • 95 to 99% of fund managers fail to outperform the distribution of alpha (the excess return over the benchmark after accounting for risk exposure) that we would expect to see from chance alone (i.e., if all the managers were simply picking stocks at random).
  • While there is a small group of “star” fund managers (the 1%) who are able to generate superior performance (in excess of operating and trading costs), they extract the whole of this superior performance for themselves via their fees, leaving nothing for investors (see this article for an explanation of this phenomenon).

The U.K. name for index funds is “tracker funds”, and the authors found that a typical UK investor would be about 1.4% a year better off by switching to tracker funds.

The methodology used by the authors was similar to that used by Fama and French in their study of U.S.-domiciled active funds, “Luck vs. Skill in the Cross-Section of Mutual Fund Returns”. Essentially, the authors compared the actual distribution of alpha to a hypothetical distribution resulting from chance (bootstrap simulation), and they found that there was very little alpha (1%) that could not be attributed to randomness. Not surprisingly, the UK researchers reached the same conclusion as Fama and French—namely that “few funds produce benchmark-adjusted expected returns sufficient to cover their costs”. As for giving you something extra beyond your costs, as Tony Soprano would say, "Fuhgeddaboudit!"

This sentence from the conclusion of the UK paper summarizes it perfectly:

"Taken together, the above results prove that the vast majority of fund managers in our dataset were not simply unlucky, they were genuinely unskilled."

While we know that passive has recently made much larger strides in the U.S. compared to the U.K., perhaps this paper will mark a turning point for them. As one of their great poets (Alexander Pope) said, “Hope springs eternal.”