Actively managed equity funds sometimes underperform their benchmarks over single months, quarters and years, usually because of bad stock picking. In the FE Invest team, we tend not to worry too much about these single periods of underperformance – provided the manager maintains a consistent investment approach that quantitative and qualitative evidence suggests will add value for investors over longer periods of time.
However, longer periods of underperformance and highly consistent underperformance are more worrying. They can signal that the investment process has changed or is fundamentally flawed, not just that the manager has stuck to his or her guns with a few dodgy stock picks. We recently investigated the incidence of active equity fund underperformance between 2015 and 2018, and identified in which sectors it was most prevalent.
Results based on 2015-2018 cumulative performance
The table below shows some key statistics from our look at the cumulative performance of active equity funds between 2015 and 2018. Underperforming funds are those that underperformed their respective benchmarks on a GBP total returns basis over the three-year period.
Source: FE Analytics
The first important point to note is that slightly more funds underperformed than outperformed over the three-year period. Some 53.3 per cent, or 396 funds out of 743, made less than their respective benchmarks.
These underperforming funds accounted for £241bn in assets as of the start of 2017. Assuming each fund’s latest ongoing charges figures held in each of the three years, we have estimated that £7.8bn was paid in fees for these underperforming investments between 2015 and 2018.
The median rate of three-year underperformance among these funds was -6.7 per cent, which amounts to a small but non-negligible average annual rate of underperformance of -0.89 per cent. These results suggest that between 2015 and 2018, a majority of actively managed equity funds weren’t worth their fees. Investors could have put their money in cheaper index trackers and made more money. However, there are several problems with this argument that we will come back to after a breakdown of the results by IA sector.
Looking at the incidence of underperformance across IA sectors, UK equity fund managers emerge as the worst performers over the period. Over a third (33.6 per cent) of the underperforming funds that we have identified were either in the IA UK All Companies or IA UK Equity Income sectors, both of which had higher incidences of underperformance than the sample as a whole.
Why did active UK equity managers fare so badly? One of the main explanations would be the one-off Brexit vote in June 2016.
In the years leading up to the referendum, many UK equity funds were running particularly high allocations to medium-sized companies. The graph below shows one-year rolling excess returns for the IA UK All Companies sector and FTSE 250 relative to the FTSE All Share.
The sharp fall in the relative performance of the FTSE 250 in June 2016 illustrates that the medium-sized companies were hit particularly hard by the vote to leave in June 2016 because they are typically more exposed to the domestic economy than larger companies which, while domiciled in the UK, generate more of their revenues overseas.
Consequently, a significant proportion of funds in the IA UK All Companies sector underperformed the broader UK equity market, which helps explain why this sector performed so badly in relative terms compared to other IA sectors.
Source: FE Analytics
Breaking down UK equity funds further, the incidence of underperformance in the IA UK Equity Income sector was much higher than in IA UK All Companies – suggesting that funds with explicit yield targets struggled much more to outperform the UK equity market than funds focusing on overall performance.
Over 85 per cent (50 out of 57) of IA UK Equity Income funds underperformed their benchmarks – some variation of the FTSE All Share index – over the three-year period. The sample is less than half the size of the IA UK All Companies sector, but both the sample size and the difference in the proportion of underperforming funds between the two UK equity sectors are still large enough to warrant further investigation.
Firstly, it is important to point out that equity income funds by their very nature focus on generating income as opposed to overall performance. Indeed, the IA website states that the UK equity income sector contains only “funds which invest at least 80% in UK equities and which intend to achieve a historic yield on the distributable income in excess of 100% of the FTSE All Share yield at the fund's year end on a three-year rolling basis and 90% on an annual basis”.
Therefore, it may be in appropriate to compare the two sectors on overall performance alone. Nevertheless, income feeds into total returns meaning this measure of performance can still be used as some basis for comparison.
The graph below shows that the Brexit vote was a great leveller for the two UK equity sectors. UK equity income had been outperforming both IA UK All Companies and the broad UK equity market in the run-up to the vote. UK equity income funds evidently suffered more than their all companies peers from the vote to leave and were unable to regain ground after that, dropping off compared to the market and UK all companies sector.
Source: FE Analytics
One reason why UK equity income funds did relatively poorly on and following the Brexit vote in terms of overall performance was that they generally had higher allocations to domestically focused ‘bond proxies’ than standard UK equity funds, mainly for their more stable dividend payments. While this evidently paid off ahead of the vote, they were hit harder by the vote to leave as stocks with a stronger domestic focus lost favour.
Also, in order to meet their income targets following the referendum, these funds missed out on some of the gains that the standard UK equity funds made by rotating out of domestically focused mid-caps. This is because these stocks still offered the highest and most stable dividends.
In conclusion, our results suggest that more actively managed equity funds underperformed than outperformed between 2015 and 2018 and UK equity managers suffered the most to meet or beat the market, mainly because of the one-off Brexit vote. However, there are a few important points to note about the results that have been used to reach these conclusions.
Firstly, since we have only looked at cumulative performance over the three years, the funds could have outperformed their benchmarks in one or two years, or even all but one of the 36 months, only for all of the underperformance to come in the remainder of the period. Therefore, investors could still have beaten the market by buying and selling at the right times, meaning underperformance over the period as a whole might not have been as harmful as we have made out.
Also, even if the underperformance was spread evenly across the three years, the fund may go on to significantly outperform its market over five or 10 years, which may be the real periods over which the majority of investors are looking for active management to produce market-beating returns. The first hurdle at least can be overcome by looking more granularly into performance over the three years which is what we have done
Results based on discrete calendar year performance
With this in mind, we also looked at performance in 2015, 2016 and 2017 and funds which underperformed their respective benchmarks in all three years became the ‘underperforming funds’. The table below presents a similar set of results but based on discrete calendar year performance.
Source: FE Analytics
Active managers should breathe a sigh of relief because an overwhelming majority of our sample avoided underperforming their benchmarks consistently in all three years. Only 7.9 per cent (59/743) failed to beat their market in at least one year. Median calendar year underperformance among these funds was -2.42 per cent. Based on assets under management at the end of 2016, these underperforming funds accounted for £35.6bn in assets, significantly less than the £241bn estimated above.
While this still sounds like a lot in absolute terms, it is equivalent to only 8.24 per cent of the total AUM of the sample. However, these funds were more generally more expensive than the sample as a whole. The underperforming funds had a median ongoing charges figure of 1.13 per cent compared to 0.94 per cent for the entire sample.
As a result, the fees paid for these underperforming funds over the three years amounted to £1.72bn, equivalent to a higher but still not massive 13.64 per cent of the total fees paid for all of the funds in the sample over this period.
Unsurprisingly perhaps, the calendar year results also suggest that underperformance was most prevalent among UK equity funds. Both IA UK All Companies and IA UK Equity Income had higher proportions of underperforming funds than the sample as a whole.
The IA UK All Companies sector had a particularly high proportion of underperforming funds and we had data for a relatively large number of funds in this sector, making our estimate of the incidence of underperformance more reliable.
This finding can again be attributed to UK equity managers’ high allocations to medium-sized companies leading up to the UK’s vote to leave the EU, from which they still not completely recovered.
Conclusion
More active equity fund managers underperformed than outperformed their benchmarks between 2015 and 2018. Active managers in the UK equity space emerge as the worst relative performers. However, this doesn’t mean that we would expect them to perform badly in all market conditions. The one-off Brexit vote seems to explain most of their relatively poor relative performance.
Although the total opportunity cost of active management is high in absolute terms, a significant majority of managers managed to beat their benchmarks in at least one of the three calendar years over this period, suggesting that consistent active underperformance is not as prevalent a problem as might have been feared.
Jake Hitch is a research assistant in the FE Invest team.