One of the main arguments for investing in passive funds is that the performance of the market is equivalent to the performance of all the active managers it contains. Therefore, if you can gain exposure to the market without having to pay the high active management fees, you are guaranteed to outperform the average fund.
However, this ignores an important fact: investors will not get exact exposure to the market through a passive fund as although they are cheap, they are not free, while indices become more difficult to accurately track the smaller and less liquid they are.
As a result, Albemarle Street Partners has put together research showing the equity sectors where, over a period of five years, the highest and lowest proportion of funds have beaten the tracker that represents the best value for money (in terms of minimising cost and tracking error).
Percentage of funds that beat passive option over 5yrs
Source: FE Analytics/Albemarle
Unsurprisingly, IA UK Smaller Companies comes out on top of the list, with about 90 per cent of active funds in this sector beating the iShares MSCI UK Small Cap ETF. Although there is a larger universe of stocks to choose from the further you move down the market cap scale, smaller companies tend to receive much less coverage from analysts than their larger counterparts, meaning there is more opportunity for active managers to gain an advantage.
IA European Smaller Companies also did well, with close to 60 per cent of its active funds beating the iShares STOXX Europe Small 200 UCITS ETF.
In second place was the IA UK Equity Income sector, with 80 per cent of active funds beating the Vanguard FTSE UK Equity Income Index. Active managers have been given a helping hand in this market, whether they wanted it or not. Royal Dutch Shell has made up more than 10 per cent – the maximum position size permitted by an OEIC – of the FTSE 100 at many points over the past five years, meaning active managers have been forced to take an underweight position in the stock.
This worked in their favour last year when the oil price crashed from $61.18 to a low of $11.26 in April, following a price war between Russia and Saudi Arabia and the hit to demand from the coronavirus. Shell lost 40.81 per cent over the 12-month period.
Performance of fund, equity, sector and index in 2020
Source: FE Analytics
Perhaps surprisingly, the sector where the lowest proportion of active funds beat the best value tracker was not IA North America, but IA UK All Companies. The S&P 500 is famously difficult to beat, as it is highly efficient and a large number of analysts cover each stock.
There is a perception that outperformance is much easier for the IA UK All Companies sector – because its funds can invest in stocks of any size, critics point out they can outperform simply by tilting their portfolios towards smaller companies, which tend to deliver higher growth. However, just over 20 per cent of IA UK All Companies funds beat the iShares UK Equity Index over the past five years.
This can be partly attributed to the large proportion of managers in the sector who take a value approach.
Charlie Parker, managing director of Albemarle Street Partners, said: “An enormous amount of the fund management community makes its money and has processes built on looking for value, and that basically stopped working over the last five years.
“Managers in the UK were not in a position to perform for a very long time.”
However, he pointed out this all changed towards the end of last year when positive vaccine news led to a rally in the most battered stocks. Parker said this may hint at the shape of things to come over the longer term.
“Q4 saw this enormous rotation that we’ve all been waiting for, from quality growth – led by the US – to a value-led market recovery, where we saw the UK outperforming,” the managing director continued.
“This year there is a very strong likelihood of economic expansion, so that helps cyclical companies. And we would say that those economies that locked down the most and saw the biggest GDP hit are going to get the biggest economic boost from the vaccine.
“That is really the UK and Europe. You’ve got more rapid growth expansion in the UK and Europe than other regions and then you’ve also got the fact that they’re just much cheaper.
“When we look at our expected returns for each market, we’ve already got higher expected returns there, just because of the cheapness.”
Percentage of active funds that beat passive option in Q4 2020
Source: FE Analytics/Albemarle
As a result, value mangers dominated the list of best performers in Q4; yet despite these favourable conditions, the proportion of IA UK All Companies funds that beat the iShares UK Equity Index was still less than 60 per cent.