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Future of actively managed funds debated

Cape Town - There is currently a great deal of scepticism doing the rounds in the international news media about the future of actively managed funds, according to Yolanda Naudé, head of fund research at Citadel.

She says this describes a strategy where a fund manager selects individual financial securities and aims to outperform a specific stock or bond index.

"Some are even speculating that the great shift into passive solutions - which aim to mimic a specific bond or stock index - could mean the end of the actively managed fund industry as we know it," said Naudé.
 
According to research by Goldman Sachs, only about 10% of large-cap core funds in the United States beat the S&P 500 - the 500 largest listed stocks in the United States - last year. This is their worst performance in decades.

Global managers - who pick stocks worldwide - have not fared any better. According to a recent Vanguard study, based on Morningstar data, around 80% of emerging market equity managers, 77% of global equity managers and 53% of global bond managers have not beaten their own stated benchmarks over the past five years.

The industry’s reaction to this underperformance has been sharp and severe, says Naudé, with a significant shift in assets away from actively managed funds into passive solutions.

In 2014 alone, active equity fund managers in the United States lost nearly $100bn, while passive equity funds in the country attracted nearly $170bn in new flows.

"This trend that had been confined to the United States has now, to a large extent, been replicated globally," said Naudé.

Why the underperformance?
 
She explains that research points to the fact that, historically, actively managed funds tended to outperform their passive counterparts when dispersion - the total variance in returns between stocks - and volatility - the extent to which stocks move up or down - are high, and correlation - among individual stocks or sectors or geographical regions) - is low.

"These conditions typically create a fertile ground for active fund managers to pick winners and avoid losers. However, when dispersion is low, markets are not very volatile and correlation is high, then the active investment is typically not rewarded and there is less to be gained by following this approach," said Naudé.
 
"Active fund managers also typically have a bias towards smaller cap stocks. These stocks tend to be overlooked with less analyst coverage than many of their larger cap counterparts. In the past, many active managers have been handsomely rewarded by strong stock selection in this part of the market."  
 
When measured by, for example, the Russell 1000 (the smaller listed companies in the United States), dispersion in 2014 was the lowest in over three decades. It was also a year of generally low volatility.

In addition, we experienced an unusual negative size premium (that is, large companies outperformed small companies). The 100 largest listed companies in the United States outperformed their smaller counterparts by more than 15 percentage points during the year, despite small-cap company earnings growing at nearly double-digit rates.

"In fact, in 2014 small-cap funds underperformed their large-cap peers in the United States by the most in about 15 years. Certainly, if actively managed funds had not held Apple (up about 40%) and Microsoft (up more than 30%) in 2014, then they would have lagged the market by nearly 180 basis points as these two mega-caps posted stellar performances during the year," said Naudé.  
 
Currency movements also had a sizeable impact on returns measured in dollars for many global funds that were underweight in the United States, during a year which saw the US dollar appreciate against most other currencies. For example, the greenback was stronger against sterling and the euro by 6% and 14% respectively.
 
"Active fund managers currently find themselves in a challenging position. In terms of asset flows and perception, the tide is strongly against them," said Naudé.

This reminds her of stock investor, businessman and philanthropist Sir John Templeton’s famous quote: “The time of maximum pessimism is the best time to buy.”

She says this quote normally refers to times of pessimism in markets (which often create good long-term buying opportunities) regarding individual stocks.

"However, when assessing active fund manager returns versus their passive peers in 2014, Sir John’s advice could well relate to actively managed funds in the future," said Naudé.
 
"If low dispersion, a lack of volatility and high correlation among individual securities and sectors are part of the reason for active managers having struggled in 2014, then Sir John’s advice should be taken seriously."

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