Why should you buy actively managed funds? The fund management industry used to have a good answer to that: because they were experts in their field and therefore capable of providing investors with long-term outperformance over the market as a whole. Paying a few percentage points a year to access their skill was cheap at the price, given what you got back.
That’s not an argument that washes particularly well any more. Most studies show that it is all but impossible for a fund manager to stay in the top quartile for performance for more than a couple of years at a time: one of the best indicators of being in the bottom quartile over a five-year period is having been in the top quartile in the previous five-year period.
Worse for those who want to believe that the most important thing in investment is fund manager skill is the persistence of studies showing that it just isn’t — cost is.
The latest data come from Russel Kinnel, director of manager research at Morningstar. According to his very comprehensive work, total expense ratios are — more than anything else — “proven predictors of future fund performance”. The cheapest funds were found to be “at least two to three times more likely to succeed than the priciest funds”. That was the case “across virtually every asset class and time period”.
Buy cheap and you have a significantly better chance of making money than if you buy expensive. Cost is therefore the first thing you should look at before you buy any fund in any sector.
This doesn’t negate the idea that fund manager skill matters. After all, excellent managers often have high conviction in their ideas and hence low turnover. In these cases, skill is the cause of low costs (buying and selling shares all the time can get expensive). But it does make it pretty clear that you should not accept the argument that you get what you pay for when you buy a fund management service. If the overall cost of owning is high, you probably don’t.
The good news is that the active fund management industry is exceptionally clever. That cleverness doesn’t always extend to creating good retirements for those of us who are not employees of the industry. But it has set itself to work to find new justifications for its existence.
The latest is stewardship. Someone has to be responsible for keeping an eye on capitalism, say fund managers. Someone has to make sure corporate governance is up to scratch; someone has to see that boards consider stakeholders rather than just shareholders; someone has to make sure executive pay doesn’t go nuts; and someone has to pay for that (the former four someones being them and the latter someone being you).
This isn’t nonsense. As Lindsay Tomlinson, a CFA fellow, says in the CFA Society’s latest report on the matter, “the job of sitting between asset owners and companies is a massive responsibility” and one that most people don’t realise that fund managers take on. The asset management industry should therefore spend more time “demonstrating the good it does for society and individual savers”, says Mr Tomlinson. It needs to “get out there and tell its story”.
I’m not sure I’d do that right now. Why? Too many examples of totally rubbish stewardship or no stewardship at all spring to mind. It is nice, for example, to see something of a “ shareholder spring” this year (various big fund managers have voted against various obscene pay packets for the chief executives of listed companies).
But if there had been anything but the most hopeless of stewardship over the last few decades we wouldn’t have to worry about the social and financial distortionary effects of the likes of Aviva paying its boss £5.6m a year. Because they wouldn’t be.
I suspect that things will improve from here: that by necessity active shareholders will start to make more noise about these things, if only to look like they are doing something useful. But I’m afraid it isn’t going to be enough to make their investment case for them. If they do it really well there will be an argument for society to praise them (which will make quite a change). Yet there still won’t be much of an argument for individuals to buy their funds.
After all, most of us would probably still be better buying cheap passive funds (the managers of which are beginning to talk about stewardship as well anyway) and holding them for the long term. We’d still get any benefits there might be from good fund manager behaviour but without having to pay for them. We are all free riders at heart.
Still, regular readers will know that I have a lot of sympathy with some active funds (see past columns for the way to find the ones I think work) and that I have a particular affection for investment trusts — which have a history of low-cost outperformance. They will also know that I don’t think the evidence for passive over active should blind us to obvious opportunity. This brings me back to Aviva which for reasons known only to itself (and presumably its very highly paid staff) appears to be selling out of its holdings of all investment trusts, something that is pushing their share prices down so that they are selling at attractive looking discounts to their net asset values (NAV).
Aviva has sold out of its stakes in both Mercantile and Witan, pushing their discounts out to just over 10 per cent and 6 per cent respectively. It is also a top five shareholder in trusts such as the Scottish Investment Trust and Electra Private Equity (there is a full list on the AIC website).
What should you do? Think about buying some of the things Aviva is selling, says John Newlands, head of investment companies research at wealth manager Brewin Dolphin. He is finding it hard to see “the long-term wisdom of dumping investment trust holdings, some of very considerable quality, at significant discounts”. But their foolishness might be your chance to buy good funds cheap: “Witan Investment Trust, for instance, offers sound long-term value at any sort of discount.” So buying it on a discount of 5-6 per cent now may be no bad thing. You’ll be wondering what its total expense ratio is. The answer? 0.87 per cent. Cheap enough to have a good chance of outperforming.
“The Value of the Investment Profession, A Report on Stakeholder’s Views” is a CFA report, referred to above, in which I appear, making a few quite nice and a few stern comments on the fund management business.
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