How to improve the odds of picking a winning fund

Passive investing is popular, but in certain markets, active funds still deliver superior returns.

The past decade has seen increasing numbers of investors switching their money out of actively managed funds and into index tracker funds, either traditional index funds or exchange traded funds.

There are several reasons for this. Tracker funds are generally cheaper to run, so their fees are low compared with active funds. Meanwhile, many investors burned in the financial crisis have decided that active managers are not all that good at protecting capital in a downturn.

What’s more, the past decade has seen increasing acceptance among retail investors of ‘the efficient markets hypothesis’. Stockpickers, the theory goes, will struggle to consistently beat the market- average performance. Some fund managers may do so, but identifying in advance which are likely to do so is exceptionally difficult.

That said, while in some markets active managers have little chance of beating their index-tracking rivals, in others they stand a strong chance of doing so.

We take a look at the markets where the active strategy has been most successful over the past decade and those where it has been least effective, and explain the reasons behind this.

In order to compare active versus passive returns, we have used Morningstar’s success rates over the 10-year period from 2009 to 2019. The success rate measures the performance of Europe-domiciled active funds against passive peers in their respective Morningstar categories (which are more granular than the Investment Association sectors we usually refer to). It is defined by Morningstar as the percentage of funds that survived and also went on to generate returns in excess of passive fund returns in the same sector, over a specific period.

The success rates for large-cap, regionally focused funds are among the lowest. US large-cap growth has a success rate of 1.5%, indicating that just 1.5% of funds survived and outperformed the average passive fund in the sector over the past 10 years. The Europe large-cap blend sector achieved a slightly better rate of 15.5%, but this is still a lot lower than the 35.3% the region’s small-cap sector, Europe small-cap equity, produced.

It’s no surprise that large-cap-focused fund managers have had a lower success rate relative to index trackers, says Darius McDermott, managing director at Chelsea Financial Services. He points out that larger companies make up the most efficient parts of stock markets.

He says:

“They are the companies covered by the largest number of analysts and information about them is widely available. That makes it hard for investors to find an angle others have not thought about and therefore add value.”

Indeed, this point about efficiency applies to the US market more broadly. Overall, the region has some of the lowest success rates. Even the US small-cap equity sector, which is relatively less closely analysed, has a lower success rate than the equivalent sectors in Japan and  Europe, as can be seen in the table.

The explanation is the same as that for the low success rates among large-cap funds: coverage and efficiency. The US market is the most watched and analysed in the world: even small US equities are closely studied. Again, this makes the task of beating the market much harder for active managers.

Leading Morningstar equity sectors: active fund success rates

Source: Morningstar Direct, as at 30 June 2019

Structural factors

The structure of a market – the balance of different industries that comprise it – is important. Again, this can be seen by the abysmal performance of US large-cap growth. McDermott argues:

“US large-cap growth stocks tend to be technology companies, which have done very well in recent years and make up a huge part of the index.”

However, it is almost impossible for active managers to be overweight any of these stocks (assuming they have conviction in their performance) without breaching percentage holding rules.

Adrian Lowcock, head of personal investing at Willis Owen, makes a similar point: “Active managers are likely to be underweight in some of the best performers in the growth area, such as Apple (NASDAQ:AAPL) or Amazon (NASDAQ:AMZN), as these comprise so much of the index that active funds cannot go overweight because of risk controls. The growth area of the market has been highly concentrated into a few stocks – if you don’t have over-exposure to those, you will struggle.”

All of this means that managers investing in large-cap US growth stocks have been much more likely to underperform their index-tracking peers.

Promising territory

On the other hand, sometimes the structure of a market is more favourable to active managers, as in the Indian market, where they have a success rate of 47.6%, one of the highest.

McDermott points out that stock market indices in India are heavily weighted towards a handful of large conglomerates.

In the MSCI India index, for example, just two companies account for 22% of the entire market.

However, Ben Yearsley, director at Shore Financial Planning, says: “The larger stocks are often financial or big, messy conglomerates that have been poor performers.” Active managers have been able to avoid these parts of the index, and instead construct portfolios of smaller- and mid-cap companies.

According to McDermott:

“When the mid-caps do well, they do very well; when they fall, they can fall a long way. So they are a lot riskier. But over time they can be very rewarding, as they have so much room to grow.”

Primed for change

Lowcock argues that active funds sometimes stand a better chance of preempting big economic changes. He says: “India has been going through some big changes under its current prime minister, Narendra Modi, and these changes will have had an impact on the market. Tracker funds are subject to changes in the market, while active funds can preempt these changes and avoid the companies worst affected.”

Market structure has also played a large role in the success of active management in the UK mid-cap space, says Jason Hollands, managing director at Bestinvest. UK mid-cap has the best performance of all Morningstar sectors, with a success rate of 77.8%. This was the only sector with a success rating above 50%, so it was the single sector where investors were more likely than not to achieve better results with an active manager.

Active management has also been able to find more traction in both the Indian equities and the UK mid-cap sectors, because these are less efficient parts of the market. In contrast to the heavy analyst coverage in US sectors, there is less scrutiny here.

However, Hollands says: “The structure of the UK market and concentration at the top are undoubtedly factors here.” There are 626 constituents in the FTSEAll-Share index, and while 40% of these are mid-caps (under the FTSE definition) and 44% are smaller companies, when weighted by market cap, the index is 80% exposed to large companies, 17% to midcaps and just 3% to smaller companies.

“In other words, 84% of the market’s constituents are zapped down to 20% of its market cap,” he adds. “By definition, active managers prepared to move away from the index and play more heavily in the mid- and small-cap spaces will be giving themselves exposure to a much bigger opportunity set.”

McDermott makes the point that the UK mid-cap sector has seen strong performance because of the quality of active managers focused on the market. He says: “We have some very good active managers in the mid- and small-cap spaces: some of the best stockpickers in the world who really know their home market inside out. They consistently add value.”

Lowcock makes a similar point. He says: “The UK fund management industry has been exceptional at finding opportunities in this space. Some of this is because the mid-cap sector in the UK is still just too small for many of the largest asset managers and institutions.”

Smaller company stars

The Morningstar UK mid-cap sector has a success rate of 77.8%. The closest equivalent to that in terms of Investment Association sectors is the smaller companies sector.

Over the past 10 years this sector has produced an average return of 229%, making it the third best-performing IA sector.

Topping the table was Merian UK Smaller Companies, which returned 414% over 10 years. Note that investors in Marlborough UK Micro Cap Growth and LF Gresham House UK Micro Cap would be unable to access many of their constituent holdings via a passive fund anyway, because they are listed on the Alternative Investment Market, for which no tracker or ETF exists.

UK smaller company top performers

Source: Morningstar Direct, as at 17 December 2019

Beaten bonds

On average, the success rates of bond funds are lower than those of equity funds. Does this suggest that active management is better suited to equities?

Not necessarily, says Lowcock. The failure of active bond funds to achieve a high success rate is “actually a scary thing about how data can be interpreted”, he suggests.

He argues that passive funds will buy the most heavily indebted companies, as they issue the most bonds. While the performance of these bonds can be good for a period, possibly even the life of the bond (benefiting the passive fund), “the risk that has been taken by the passive fund is much higher than is realised”.

He says:

“It is not just about performance; it is about risk management as well. No active bond manager would buy a company’s debt just because it comprised more of the market.”

Bond markets have also been supported by quantitative easing, giving passive vehicles an easier time, says McDermott.

“A decade of extraordinary monetary policy has distorted the bond markets and arguably kept a bond bull market going a lot longer than it should have.”

He adds: “Active bond fund managers will think about risk as well as reward and therefore will have been shorter duration, which will have hurt in terms of returns, but is definitely the sensible course of action.” Should monetary policy start to tighten again, McDermott says, “a skilled and experienced bond manager will be where to have your money”.

The struggles of bond fund managers in an environment of ultra-loose monetary policy can be seen in Japan, where fund managers have a success rate of just 5.9%. McDermott says:

“The Japanese bond market has been completely manipulated by the Japanese central bank to keep Japan’s economy afloat. Many bonds have negative or zero yields.”

Lowcock concludes that in such a market, it is “almost impossible for active managers to add value unless they accurately predict the central bank’s actions”.

Leading Morningstar bond sectors: active fund success rates

Source: Morningstar Direct, as at 30 June 2019

Value versus growth debate

The value versus growth debate is almost as important as the active versus passive one. Morningstar data shows that value investing has a better chance of success than growth investing for active stockpickers. US large-cap growth has a success rate of just 1.5%, while the rate for US large-cap value is 7.2%.

The better performance of value is partly down to the inherent selectivity of value investing. Investing in value entails trying to find good firms that are out of favour. This requires a highly selective approach, in order to avoid unloved firms that have no future.

Jason Hollands says active management, in theory, can “avoid land mines and spot the genuine bargains with rerating potential, which provides more scope for success”.

There is, however, a more specific reason for value’s better success rate over the past decade. According to Hollands, much of the strong performance of US large-cap growth stocks has resulted from share buybacks. But he says US active value and blend managers have been able to do better “because these parts of the market have been least influenced by the buyback bonanza”.

Typically, they are more conservatively financed and “more likely to pay dividends than leverage up and gobble up their own stock”.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.