Don’t count out active management amid land grab by passives

Passive or index-tracking funds have become an increasingly important element of the investment adviser’s toolkit in recent decades, offering a low-cost way to capture (most of) the performance of an ever-expanding array of markets and asset classes.

Research published last week by retail investor platform Hargreaves Lansdown (HL) pointed to an increase in passive funds’ market share from about 10% of the total value of mutual funds in 2010 to around 25% at the end of 2022.

But against a challenging market backdrop, how have active funds fared versus their passive counterparts?

Across the pond

HL considered two markets – the US and UK – over four time periods: calendar 2022 and 2021, and five and 10 years to end-2022. The analysts looked only at open-ended funds, so we have expanded the dataset to include closed-ended investment trusts as well.

Closed-end funds are arguably better placed to outperform, given the permanent nature of their capital—meaning fund managers do not need to sell holdings in order to meet redemptions when sentiment is negative—and their ability to invest more than 100% of their underlying assets through the use of gearing.

We have looked at NAV rather than share price performance for the investment trusts, as this reflects the performance of the underlying holdings, and is therefore most analogous to the index and open-ended fund returns.

*Includes both the UK All Companies and UK Equity Income sectors.

Asking the right question

HL described the output of its analysis as ‘all a bit damning’ for active funds. “They seem to struggle to outperform with any sort of consistency and are becoming less popular over time,” said senior investment analyst Hal Cook. However, he went on to stress that the figures are averages, and while the average open-ended fund manager did not outperform either market over any period, there are many that did, and some that manage to do so with a good degree of consistency.

In essence, the question is perhaps not ‘is active better than passive’, but ‘what do I (or my client) want in my portfolio’. If the answer to the second question is simply ‘market exposure’, then a passive fund is the best way to achieve that, in the full understanding that the value of assets will fall as well as rise with the market in question. The S&P 500 in particular is renowned as a highly efficient equity market, where it is hard to get an information advantage.

Tech titans versus investment trusts

This perhaps explains why the world’s largest equity market is one of the smallest investment trust sectors, with only seven North America funds, two of which are actually specialists in Canada, while one (Pershing Square Holdings, or PSH) takes an activist approach and holds only nine stocks. PSH can take both long and short positions (although it is currently long only), and as such it was classified in the AIC’s Hedge Funds sector until its relatively recent move to the North America group.

The US market has been massively driven in recent years by mega-cap technology stocks such as Apple, Microsoft, Amazon, and Alphabet (Google), the four largest stocks in the FTSE USA index (a reasonable proxy for the S&P 500) at the end of 2022. Yet as inflation and interest rates rose and fears emerged over the strength of the global economy, tech stocks sold off in 2022, ending the year at about 25% of the large-cap index’s market capitalisation, compared with 30% at the start of the year.

With those four stocks alone making up 16.5% of the index, it would take a brave active fund manager to go overweight, which would arguably have been about the only way to outperform the index in recent years, and would have all but guaranteed underperformance in 2022.

The only two US-focused funds to beat the Vanguard S&P 500 tracker’s -8.3% return in 2022 were Abrdn’s North American Income Trust (NAV total return +10.1%) and Blackrock Sustainable American Income (+2.9%), both of which are structurally underweight the ‘high-growth’ tech sector as a result of their income focus. The other trust to outperform the tracker in 2022 was Middlefield Canadian Income.

In the UK, however, the closed-ended funds in particular have a much better record versus the passive alternative, with more than 70% outperforming over 10 years, though this drops to only around one in seven of both the open-ended and closed-ended active funds in calendar 2022.

It is worth noting that the Vanguard UK tracker is FTSE All-Share focussed (thereby capturing the vast majority of the UK equity market), whereas the US passive fund tracks a relatively small proportion (by number of stocks) of the overall US market. This means the UK active fund managers largely have the same opportunity set as the passive fund, although – in the closed-ended space at least – few if any could be regarded as ‘closet trackers’.

Don’t overpay for growth

Across both the North America and UK sectors, only one trust has outperformed the comparable tracker over all the periods under consideration (although honourable mentions go to Fidelity Special Values, Law Debenture, Merchants and Murray Income for their outperformance of the Vanguard UK fund over all periods except calendar 2022).

City of London Investment Trust (CTY) is the largest, one of the oldest, and the lowest-charging trust in the UK Equity Income sector, and is also the joint holder of the longest record of year-on-year dividend growth.

Its value and income focus have served it well over the years (with a 10-year NAV total return of 105.1% versus 86.5% for the Vanguard UK tracker), although manager Job Curtis noted at the AGM in November that its mantra of ‘don’t overpay for growth’ also reaped rewards in 2022, when many attractive growth stocks the manager had previously seen as too expensive de-rated to a level at which they became attractive.

This could stand it in good stead if the value versus growth pendulum swings back the other way.