The expression ‘passive fund management’ is usually taken to cover index funds, exchange-traded funds and guaranteed funds, most of which are indexed against specific benchmarks. I have broadened the universe to include ‘closet index funds’, which I have taken to be funds which have a consistent R-square of 0.95 or higher.
Of these definitions, the least familiar in Europe will be ETFs, commonly referred to as Spiders (SPDRs – Standard & Poor’s Depository Receipts), Webs (World Equity Benchmark Shares), Diamonds and QQQs. These were introduced on Amex in 1993 and have grown to a current value of $37bn, accounting for 85% of the value traded on Amex on a typical trading day. They have proved immensely popular in the US, charging average management fees of only 18 basis points compared to ‘active’ fund fees now averaging 180bps, and replicating the index, almost exactly, by the use of derivative products.
On the broad definition given above, it is estimated that US institutional and retail funds are split 50/50 between active and passive strategies. This compares with an estimated position of 80/20 10 years ago, which I estimate is the approximate active/ passive split in Europe today. I expect Europe to follow the pattern of the US, reaching a 50/50 active passive split within 10 years.
While this extrapolation may appear overly simplistic, it is my contention that the factors driving this trend are irreversible and will be strongly influenced by institutional demands, particularly as the ‘retail’ fund industry expands into the defined contribution pension funds market.
It is traditional, and expected, to make a case for or against either the active or the passive strategies. This article will be different, including the statistics needed to support the case ‘for’ or ‘against’
Table 1 presents the case for active funds, showing that the best active funds in the UK large-cap sector substantially outperformed their FTSE All Share benchmark over five, 10 and 15-year periods to the end of 1999. The table also presents the case against, showing that the sector average fund has underperformed the benchmark, by a meaningful margin, and that the ‘worst’ funds (90th percentile and above) have underperformed by a substantial margin, over each of the measurement periods.
Turning to the case for passive funds, Figure 1 shows that more than 80% of UK large-cap ‘active’ funds have underperformed the FTSE All Share over the past five, 10 and 15 years. I should note that such results are also produced by using ‘rolling’ review dates.
Some would argue that all index funds underperform their benchmark, reflecting the impact of management charges but, as subsequent figures will demonstrate, in certain asset categories it is very difficult to make the case for active fund management.
Figures 2 and 3 show the year-by-year results for UK large-cap funds and also for US large-cap funds.
The results for US large-cap mutual funds demonstrated underperformance over five and 10 years of 80% and 79% respectively. I should note that throughout I have deleted all (titled) index funds from the source database of large-cap funds.
On the evidence of these statistics, it is difficult to escape the conclusion that, in the UK and US large-cap areas, passive strategies prevail.
However, as I hope I can adequately demonstrate, in most other areas, active fund management works better.
Next we compare the performance of both UK and US small-cap funds versus their respective benchmarks, the HGSC (extended) and Russell 2500 indices. In both the UK and US, the small-cap sector average funds have outpaced their benchmarks by meaningful margins. In the UK, 71%, 79% and 75% of small-cap funds have outpaced HGSC over the past five, 10, 15 years respectively. Using the S&P Micropal US small-cap fund database, the figures are 53%, 67% and 73%.
The statistics for Japan large and small-cap funds strongly support the case for active fund management. It should be noted, however, that for much of the period reviewed, Japan has been in a ‘bear’ market. Simply holding a consistent 5% in cash would have contributed to the appearance of much healthier figures. I would suggest, though, that the margin of outperformance is sufficient to challenge dismissal of these results by even the most ardent fans of passive strategies.
In Europe, the results approximate 50/50 over the past five, 10 and 15 years, with active funds outpacing the FTSE Europe (ex UK) Index for seven out of the past 15 years, the sector average fund in positive territory over both five and 15 years, and only marginally underperforming over the 10-year period.
Finally, in the global equities sector the statistics also indicate a healthier result with 81%, 64% and 82% of funds outperforming the FTSE World Index over the past five, 10 and 15 years.
We have also studied the impact of charges, and also of the measurement date, on statistical studies such as this.
Comparing the FTSE All Share with the Legal & General Index Fund) demonstrates near identical capital returns. However, in total return terms, the L&G Index Fund can be seen to have lagged the FTSE All Share. This is due to the impact of annual management charges being deducted from income generated by the portfolio and distributed by way of dividend. For the five years to the end of 1999 the FTSE All Share Index rose 158.7% with income reinvested, whereas the L&G Index Fund rose 150.1%.
Extending this “underperformance” for 10 and 15 years and applying this to Figure 1 the percentage of UK large-cap “active” funds underperforming the FTSE All-Share adjusted for the L&G Index Fund expense ratio, falls from 81.6% to 77.1% over five years, to 87.6% versus 73.2% over 10 years and from 88.5% to 70.3% over 15 years. It is perhaps worth noting also that the L&G Index Fund was the best performing of FTSE All Share UK trackers over this five-year performance measurement period, so one should allow for the fact that charges have adverse impact not only on active funds, but on index funds too.
Finally, results can change simply by altering the review dates. There was a consistent pattern of variance, and the results shown by the US large-cap fund sector vs the S&P 500 over two months-later performance data, were not untypical. Moving the date from December 1988 to February 1989 increased the proportion of funds underperforming the benchmark, from 63% to 88%; while moving from December 1996 to February 1997 showed the reverse effect, with the proportion of funds underperforming the benchmark falling from 82% to 60%.
My conclusions are that while passive strategies will grow dramatically in Europe, the active fund management industry will still have a vibrant business.
Peter Jeffreys is managing director, index services (Europe) at Standard & Poor’s in London