Investors are wrong to believe that tracker funds will continue to outperform their active UK rivals, according to Simon-Evan Cook, senior investment manager at Premier Asset Management. 
In 2016, investors who have taken a passive approach to the UK equity market have tended to fair better than those who have backed active funds.
According to FE Analytics, the FTSE All Share has outperformed the average active fund (as measured by the IA UK All Companies sector which is 85 per cent weighted to active funds but doesn’t have survivorship bias) by 5.76 percentage points year to date.
As such, 36 of the 38 tracker funds in the peer group are sitting in the first or second quartile in 2016 so far.
Performance of sector vs index in 2016
Source: FE Analytics
Evan-Cook says there are a number of reasons for this outperformance, but remains sceptical of the long term viability of such a strategy.
He says this is part due to the fact that we are coming off the back of 2015 – an extremely strong year for active management – in which 75 per cent of UK funds managed to beat the FTSE All Share due to a structural overweight position in mid-caps relative to the index and a general underweight position in commodity-related stocks.
“You had most active funds outperforming in 2015 – so there’s been a little bit of giveback there – a sort of rebound, a reversion to mean,” Evan-Cook (pictured) said.
“You’ve also got to look at the make-up of the FTSE All Share - in particular the miners and the oil companies - which have been pretty bad for quite a long time.”
“They make up a large part of the index, though not as large as they were three years ago as they all shrunk in size, but they could only fall so far before you hit a bottom and bounce back so that’s been happening to a certain extent this year.”
While this has undoubtedly helped to boost the index, another reason is the spiralling nature of passive funds.
Indeed, Evan-Cook notes that if more money goes into passive funds, they must buy more of the companies they are allowed to hold, increasing the value of the companies and pushing the price of the passive fund higher.
FE data shows, for example, that three of the top 10 most bought funds in the IA UK All Companies sector over the past 12 months track the FTSE All Share or FTSE 350 indices – which is an impressive figure given active funds outnumber passive funds in the peer group by seven to one.
The 10 best-selling IA UK All Companies funds over 1yr
Source: FE Analytics
“There is a massive trend towards buying passive and it spirals upwards until there’s nothing left to buy,” he said.
This happens every now and again, Evan-Cook says, with the last period being in 1999, when many bought passive funds to take advantage of the rise in the index due to the advancement of technology companies.
“That went on for a couple of years but then it was followed by an incredibly good time for active management from 2001 onwards once the tech bubble had burst.”
“The likes of Neil Woodford, Anthony Bolton had an incredible run against the index having been under the cosh for a little while before that.”
Performance of Neil Woodford vs index from 2000 to 2006
Source: FE Analytics
Indeed, a look at Neil Woodford’s performance between 2000 and 2006 shows the manager struggling early, as passives outperformed, but strong outperformance soon after.
While passive funds have been outperforming so far this year and could do so for a short while, Evan-Cook says it is unlikely to continue over the long term.
“I don’t think that markets weighted indices can do that [outperform over the long-term] it’s simply not possible for the biggest companies to keep outperforming because of the law of large numbers.”
“Eventually the chances of the biggest companies outperforming becomes improbable because why should the largest 100 companies [for example] outperform when there are thousands of companies.”
The FTSE 100 makes up 81.2 per cent of the FTSE All Share and indeed, a look over the last five years shows that the average fund in the IA UK All Companies sector has outperformed the index by 3.15 percentage points thanks largely to a structural overweight position in mid-caps relative to the index.
Performance of sector vs benchmark over 5yrs
Source: FE Analytics
“The reason we like active is because we think we are going to get much better performance by backing a properly active manager over the long term,” Evan-Cook said.
“The big argument I hear most often against active management is that the average active fund shouldn’t outperform once you take away the higher fee.”
However in the UK, the average fund has beaten the index over the last five years.
Evan-Cook added: “So even the basic argument for passive hasn’t held up. What baffles me is why there is this incredible belief amongst investors that passive investing in the UK is the best way to go when it clearly hasn’t been.”
Additionally, he argues investors should not be looking to buy an average fund.
“I understand the passive argument – if you back an average fund then the chances are that you probably will underperform which is why we don’t back average funds.”
Evan-Cook also says active funds could be less volatile than passive funds, given their uptick in popularity this year.
Over the last five years, the FTSE All Share has been slightly less volatile than the average UK fund but has posted a larger maximum drawdown. On the other hand, the FTSE 100 has been eight basis points more volatile and delivered a much higher potential drawdown.
“I think with active management you’re getting lower volatility and higher returns and yet people are still rejecting that prospect.”
