The average fund in the IA UK Smaller Companies sector has beaten the market in almost 80 per cent of the rolling five-year periods since the start of 2000, according to research by FE Trustnet, which is a far cry from the widespread underperformance of the worst peer group.
Numerous studies in recent years have highlighted the difficulties that active managers having in outperforming the market on a consistent basis. The closely watched SPIVA report from S&P Dow Jones Indices, for example, said that active funds “generally underperformed their benchmarks across all time periods”.
This was further thrust into the spotlight in 2016, when many active funds were wrong-footed by surprises such as the Brexit result and Donald Trump’s presidential victory then lagged their respective benchmarks as a result. The chart below shows the underperformance of the IA UK All Companies sector but this trend was seen in several other equity markets.
Performance of sector vs index in 2016
Source: FE Analytics
However, investors are frequently told that they should only put their money into equities if they have a long-enough time horizon with a common suggestion being that five years is the minimum they should consider for a stock market investment.
With this in mind, we looked at the performance of the average fund in the nine main Investment Association equity sectors to see how they have performed across multiple five-year time frames.
To do this, we measured the outperformance of each sector versus its natural benchmark over 51 rolling five-year periods. The study’s first period covers performance between 1 January 2000 and 31 December 2004, then moves forward on a quarterly basis until the five years spanning 1 July 2012 to 30 June 2017.
The results show a wide spread in the performance of the average fund against the index, with the most successful peer group beating its index in 78 per cent of the periods examined. On the other hand, the worst sector was ahead of the index in only 12 per cent of the five-year periods.
As the table below shows, it’s the IA UK Small Companies sector that leads the pack followed by IA Europe Excluding UK (outperforming in 73 per cent of the periods) and IA UK Equity Income (ahead of the index 53 per cent of the time).
Source: FE Analytics
There are a number of reasons why smaller companies funds are able to outperform the index on a more consistent basis than their large-cap peers.
Among the advantages that smaller companies managers have are the potential for higher growth than at the top of the index, this part of the market tends to be less heavily researched than the more visible large-cap space and there is less impact from passive investment’s distorting inflows and outflows.
Performance of sector vs index over rolling 5yr periods
Source: FE Analytics
The same trend of long-term outperformance is not limited to the UK, with the average fund in other peer groups such as Japanese and European smaller companies also showing an ability to beat the market fairly consistently over five-year periods.
However, as the table above demonstrates, the average fund in most equity sectors has failed to beat their index more than half of the time.
In the IA North America sector, the average fund has failed to beat the S&P 500 in 88 per cent of the five-year periods we examined.
Within this sector, the biggest five-year average outperformance of the index was just 3.03 percentage points. This is in contrast to the IA UK Small Companies sector, where the best five-year outperformance was by 55.93 percentage points.
Investors in US large-cap equities face almost the opposite circumstances to smaller companies funds: markets are swayed by large passive investment flows, companies are extensively covered by analysts and the ability of active managers to add value is much more limited.
Performance of sector vs index over rolling 5yr periods
Source: FE Analytics
The average fund in the IA Global Emerging Markets sector also has a pretty poor record in outperforming the MSCI Emerging Markets index, only doing so in 15 per cent of the five-year periods we examined.
This may come as a surprise given that emerging market funds are often suggested for long-term investors while being marketed as having the potential to find growth opportunities in under-researched markets where significant parts of the index are best avoided.
Japan is another sector that has tended to disappoint, with the average fund outperforming in only 18 per cent of the time frames covered in this research.
Of course, there is no such thing as the ‘average’ fund and the individual funds within the sectors covered here will have over- and underperformed the index with varying degrees of consistency. Therefore, a coming series of articles will examine the individual sectors in more detail to show which funds have consistently beaten the index for their long-term investors.