Underperforming managers should be ‘relegated’ to a second tier of funds within each Investment Association sector to await promotion to ‘Premier League’ status, according to Blue Whale Capital’s Stephen Yiu. 
The call comes as the Investment Association continues to consult on whether to include more than 200 exchange-traded funds (ETFs) into its 37 sectors for comparison purposes.
The trade body acknowledged that there was the potential for some existing sector members could be demoted or promoted across quartile rankings.
However, Yiu – manager of the £101.8m LF Blue Whale Growth fund – noted that many of the sector’s constituent active managers are failing to even outperform the MSCI World, a commonly used benchmark for the sector.
He explained: “If you plot the 10-year performance for the IA Global versus the MSCI World index, the IA Global sector underperformed the benchmark by 40 per cent. That’s a lot.
“In order to be top quartile in the IA Global for the last 10 years you only need to match the benchmark returns, so if you had a tracker fund you would be top quartile. What is the point of active management?”
Performance of IA Global sector vs MSCI World index over 10yrs
Source: FE Analytics
As the chart above shows, the average IA Global fund has made a total return of 209.23 per cent over 10 years against a 250.69 per gain for the MSCI World, in local currency terms.
Outperformance is important, said the FE Alpha Manager, because of the compounding effect.
“When I say that over a 10-year period funds underperform by 40 per cent, that’s only 2-3 per cent per annum; you can’t actually see it,” he said. “Over time [however] it accumulates: it’s compounding.”
The FE Alpha Manager said that – while it does not necessarily mean there are more bad managers or that they are not working hard enough – there are questions surrounding portfolio construction in the sector.
With many fund managers focused on risk management and volatility, the Blue Whale manager said they are reluctant to take big bets away from the benchmark.
“People should just buy the tracker,” said the LF Blue Whale Growth manager. “We are big fans of ETFs because they do outperform the majority of active funds in the market and we’re not just talking about the IA Global sector.”
Whether or not an index-tracking ETF was suitable for an investor would depend on their investment objectives, said Yiu. Yet, he conceded that given the number of strategies available could be confusing for investors.
As such, the fund manager has a more radical proposal to help investors to judge which are the best strategies available.
Rolling three-month total returns of IA Global sector vs MSCI World over 10yrs
Source: FE Analytics
“What I would say what really needs to happen in the IA Global sector is to create two tiers of funds within the sector,” he said.
“On a rolling three-year basis you would review on a quarterly basis and if a fund underperformed the benchmark then you’re in tier two, if you outperform you’re in tier one.”
Yiu explained: “It would be the equivalent of the Premier League: if you do well you stay there but if you’re not doing well you get relegated. You then have other teams in the lower tier and they can move up the table.”
It would soon become apparent, said the Blue Whale manager, that while around 50 funds will have beaten the benchmark the remainder would have underperformed.
“I think it’s an embarrassing truth about our industry that you’re going to see that it’s about 25 per cent in tier one and 75 per cent in tier two,” he added.
Another reason for the underperformance of the benchmark is that fewer managers are willing to build concentrated portfolios because of the potential for reputational damage.
“You take enough risks as a fund manager and if you’re not very good and you get them wrong it could destroy your career,” he said. “But it could happen the other way around.
“We’ve done quite well but because we are highly concentrated we [could] make a few wrong calls on stocks and we would be on the other side and underperform the benchmark significantly.”
A further performance-related issue where debate is “massively going in the wrong direction”, according to Yiu, is on costs.
The Blue Whale manager said there has been much pressure on fund managers to cut costs wherever they can more recently, particularly given the strong rise of markets since the global financial crisis and the emergence of lower-cost passive strategies.
However, he said the debate should be focused on the performance that investors are paying for instead.
“Performance is net of all fees: this is what you get if you’re investing in the fund,” the manager said. “Since starting we’ve done 22 per cent. If you buy the peer group you get 5.6 per cent.
“If I tell you we’ve delivered 22 per cent and we’ve charged you 5 per cent and there is another fund delivering 5.6 per cent and you only pay 10 basis points, why would you care? It’s about the end game and net outperformance.”
Yiu concluded: “The only people that worry about fees is fund management groups because if they underperform the benchmark the only way to keep investors is to say that they are going to lower fees, although people are still getting less.”
Performance of fund vs sector since launch
Source: FE Analytics
The LF Blue Whale Growth fund has made a total return of 22.91 per cent since launch in September 2017 compared with a 5.85 per cent rise for its average IA Global peer. This makes it the fourth highest returning member of the sector, out of 288 funds.
LF Blue Whale Growth carries an ongoing charges figure (OCF) of 0.89 per cent.