Laith Khalaf is head of investment analysis at AJ Bell.
Make no mistake, passive funds are eating the lunch of active managers, and the continued strong performance of index trackers will do nothing to staunch this trend.
Our latest Manager versus Machine report shows just a third of active equity managers have outperformed a passive alternative over the last 10 years.
In 2024 to date, it’s just 31 per cent who have managed this seemingly middling achievement.
Whether you look at the short term or zoom out and take a wider perspective, the picture remains dismal for active managers, and it’s the influential Global and North America sectors where a lot of the damage is being done.
The long-term performance of tracker funds in the key US and Global sectors has been nothing short of astonishing.
The idea that a plain vanilla US tracker fund could quadruple your money in a decade would have been beyond the wildest dreams of all but the most overconfident investors.
Yet that is precisely what has unfolded in the last 10 years. Indeed, over just the first 11 months of 2024, the average US tracker returned 27.6 per cent.
The UK may look pedestrian by comparison with the US, but a 10.5 per cent return from the typical UK tracker in 2024 so far is nothing to be sniffed at, and double what the most competitive cash rates have been offering.
Active funds have struggled to keep up because the performance of passive funds has been driven by the Magnificent Seven technology stocks – Meta, Amazon, Apple, Alphabet, Nvidia, Tesla and Microsoft.
Active managers can of course invest in these companies, and many do, but few will take on as much exposure as an index tracker.
To match a passive fund, an active US equity manager would now have to hold a third of their portfolio in Magnificent Seven stocks, including three individual stock positions above 6 per cent in each of Apple, Microsoft, and Nvidia.
Doing so would then guarantee underperformance on that portion of the portfolio, once active fees have been deducted, and place a huge burden on the remainder of the fund to beat the market, which is of course the goal of active management.
When it comes to Magnificent Seven exposure, active managers are damned if they do, and damned if they don’t.
Laith Khalaf: When it comes to Magnificent Seven exposure, active managers are damned if they do, and damned if they don’t.
The active malaise stemming from the strong performance of the Magnificent Seven also leaks across into the Global sector.
Just 17 per cent of active funds in the Global sector have outperformed a comparable tracker fund over the last decade, the lowest reading since we launched the Manager versus Machine report in 2021.
The US stock market now makes up 70 per cent of the key benchmark indices followed by global tracker funds, but active managers investing globally have been wary of taking on such a high weighting to one market.
The average global equity manager currently holds a sizeable 59 per cent of their portfolio in US stocks, but that’s still around 10 per cent below the typical tracker fund.
When returns from the US have been so much more impressive than the rest of the world, that underweight position really hits active managers where it hurts.
Together the Global and North America sectors account for £317billion of assets, and the large number of funds they contain means weak active performance in these areas casts a shadow across the aggregate figures for active equity managers as a whole (using sector value data from the Investment Association).
Consequently, it seems pretty inevitable that unless and until there is a reversal of the dominant performance of the US stock market and the big tech stocks within it, this report will continue to paint a bleak picture of the fortunes of active managers.
Active fund management is in a critical condition
Active managers aren’t just suffering in terms of performance relative to their passive peers, they’re losing the battle for flows too.
The last three years have witnessed an unprecedented rout for active managers in terms of fund flows.
Since the beginning of 2022, £105billion has been withdrawn from active funds and £48 billion has been invested in passive funds, based on AJ Bell analysis of Investment Association data.
The exodus from active funds shows only the most minimal signs of abating, with 2024 withdrawals on course to come in just below those of last year’s record-breaking outflows.
Investors are drawn to passive funds because of their simplicity and their low cost, not solely their performance.
But if we lived in a world where trackers were cheap and cheerful, but tended to deliver worse outcomes, the traffic from active to passive wouldn’t be quite so one way.
It’s possible to point to a reinforcing market cycle at play here. Superior passive performance leads to money flowing out of active funds and into trackers.
Liquidations of active portfolios dent the stocks held by active managers and the proceeds flowing into passive funds put upward pressure on the stocks held in tracker portfolios. This will in turn tend to improve the relative performance of passive funds, and the cycle begins afresh.
Despite the inflows into passive funds, over the last three years there has still been a £56billion net withdrawal from open-ended funds in total (numbers don’t add due to rounding).
This reminds us that active funds aren’t just competing with index funds, they’re competing with all the following alternatives:
– Investment trusts, where wide discounts tell us demand is also weak;
– ETFs, which are seeing record global flow;
– Bitcoin, now held by seven million adults in the UK, according to the Financial Conduct Authority;
– Expenditure, as the cost of living crisis dented the propensity to save and invest;
– Mortgages, which are worth overpaying at higher rates
– Cash, where competitive interest rates have gone from close to zero to around 5 per cent in the last three years.
In 2021, the FCA identified 8.4 million people holding more than £10,000 in investible assets wholly or mainly in cash and targeted a 20 per cent reduction in that number as part of its strategy.
But by 2023, this figure had risen to 11.8 million people.
If we lived in a world where trackers were cheap and cheerful, but tended to deliver worse outcomes, the traffic from active to passive wouldn’t be quite so one way
Rachel Reeves can also take a bow for prompting a flurry of outflows from investment funds.
In the lead up to the Budget, rumours of a capital gains tax raid were plentiful, and some appeared to have been sourced from within the Treasury.
In September and October, over £9billion was withdrawn from investment funds by retail investors, as they scrambled to encash profits ahead of a possible capital gains tax raid, according to data from the Investment Association.
It’s reasonable to suppose that the surge in passive fund sales must end somewhere, but we may still be a long way from that point.
Trackers currently make up 24 per cent of funds run by Investment Association members.
But in the US, the value of assets in passive funds overtook active funds for the first time last year, according to Morningstar.
In other words, more than 50 per cent of fund assets were invested passively.
The index investing megatrend began in the US, so it sets a meaningful roadmap of where the UK investment industry may end up.
In other words, don’t bet the house on a revival in active management anytime soon.
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