Investors who saw their funds fall harder and faster than the market were always likely to question the wisdom of investing with a fund manager at all. Cynicism over investing in equities has taken a long time to repair, according to fund sales data, with savers preferring the relative safety of bonds until recently.
And cynicism about active management could take even longer to overturn, judging by the boom in passive products that is well underway.
However, there are reasons to believe that now could be a very good time to invest in an active fund.
Competition from passives is pushing fund houses to up their game, according to Laith Khalaf (pictured), head of corporate research at Hargreaves Lansdown, while the financial crisis has underlined how important it is for managers to be able to make strong active calls.
Khalaf says that benchmark-aware funds that make minimal bets against the index are living on borrowed time and being squeezed by passive funds and truly active alpha-seeking portfolios, which offer investors a better chance of outperforming in a future crash. "Being benchmark-aware, you have to be careful that you are not falling into the trap of simply mimicking the benchmark," he said.
"There has been an expansion of passive funds which are benchmark-aware to the n-th degree."
"The big pension funds are very benchmark aware and there’s a question whether that means failing conventionally is better than succeeding unconventionally."
"A lot of funds are run on the grounds that you don’t want to stick your head above the parapet."
"Ideally you want a different approach, which is to invest in the opportunities out there and where you are going to make money."
"There’s a drift away from benchmark-aware products towards more of a divide between a passive or a properly active alpha approach."
"Anecdotally, it would seem to me funds are moving into those two directions and the middle ground is becoming thinner."
Khalaf says that how Scottish Widows has developed its range is a prime example of this process in action.
"They had a lot of benchmark-aware active products and decided to reform their range and have just passive products and alpha products," he said.
A number of high-profile managers have spoken openly of their determination to take a more conviction-led approach in the coming years.
Alex Breese took over the £640m Schroder UK Equity fund this summer when Errol Francis left to join Old Mutual with Richard Buxton.
He told FE Trustnet yesterday that he wanted to turn Schroder UK Equity into a more slimmed-down, high-conviction portfolio.
Ben Whitmore took over the £1.9bn Jupiter Income fund from Anthony Nutt in January; he has also outlined his determination to make the fund more conviction-driven and less benchmark aware.
This style has worked very well for Whitmore’s Jupiter UK Special Situations fund since he took it over in 2005: our data shows it has returned 85.55 per cent over five years, significantly outperforming its sector and benchmark.
Performance of fund, sector and index over 5yrs
Source: FE Analytics
Khalaf says this process is being driven by the need for active managers to differentiate their products from the ever-more popular passives.
This could, therefore, be a good time to be investing in the falling number of active managed funds that are determined to prove their worth against passive vehicles.
Investors saw an example of the dangers inherent in the latter over the summer when the markets crashed and the worst-performing funds were passives.
Khalaf points out that going for a tracker has severe drawbacks, not least that the funds cannot avoid sectors in severe difficulty.
Funds that avoided banks in 2008 – as Neil Woodford did – outperformed, while many of the funds that have done best over the past year attribute this to having nothing in mining stocks.
Khalaf explains that benchmark-aware funds appealed to fund groups in the past for two reasons.
"The first is cost: if you are running a benchmark-aware product, it is probably cheaper than if you have to pay more for a manager and for resources to do research," he said. "That probably hasn’t changed."
"Secondly, there’s the question of risk and obviously there are different kinds of risk and the risk is that of being different and underperforming the benchmark. A lot of institutions don’t want to take this risk."
The risk for groups is that of underperforming competitors and seeing a loss of assets, Khalaf explains. It is important to recognise that profits for asset management firms depend more on how much money they control rather than how well they do with it.
The risk for investors is seeing their neighbour or colleague making more money than them over a short time frame and switching funds before an active manager’s strategy pays off.
Chris Mayo (pictured), investment director at Wells Capital, says that the development of passives in this country is being driven by investor risk aversion.
"We have had an active range of model portfolios for five years, but last year launched a range of passives on the back of demand among IFAs," he said. Khalaf points out that even the best managers are criticised when they underperform over short time frames.
"Woodford has made some big calls and underperformed and people have turned against him," he said.
"Even if he has occasionally been premature, over time they have proved to be correct. Often people can’t see through short-term performance against the benchmark."
Mayo points out that equity income managers have less freedom of movement than growth managers, as the number of stocks they can invest in is restricted – a high proportion of dividends are paid by a small number of companies.
However, Woodford is one manager to have made large active bets, including ignoring the banks in the run-up to 2008 and avoiding tech in the lead-in to the previous major crisis.
The manager’s Invesco Perpetual Income and Invesco Perpetual High Income funds both underperformed in 2009, 2010 and 2012, falling into the bottom quartile in each year.
However, the manager’s funds are still at the top of the tree over 10 years, and have moved in and out of the top quartile over three and five years as short-term performance has fluctuated.
Performance of funds over 10yrs
Source: FE Analytics
Khalaf says that the pressure to follow the crowd is particularly strongly felt in the old IMA Balanced Managed [IMA Mixed Investment 20%-60% Shares] sector even now.
"Most of the money there is run looking to where everybody else is investing, so if you see more managers investing in US equities, then everybody else does too."
However, the financial crisis exposed the dangers of this approach, he explains.
"The financial crisis has highlighted that you probably want to take a more absolute view on the market."
"In 2008, the market fell 40 per cent or so, a downside of 40 per cent, and the average balanced fund lost 30 per cent. Nobody gets the average exactly, but that’s still a bad place to be."
"So the lesson is to look to more truly active products."