It is a shameful indictment of the investment industry that too many mutual fund managers charge fees for active management when in fact their stock selection is replicating a given index against which they are benchmarked, and their performance judged.
In a move to pressure investment management companies to make their investment objectives and benchmarks (a comparative index against which a manager’s relative performance may be measured) clearer and easier for investors to understand, the FCA is targeting so called ‘closet trackers’. Investment Funds that charge high fees for active management, but in reality, do no more than ‘hug the index’. The security selection held by the fund manager replicates that held in the index. Managers fear consistently failing to beat the index resulting in reputational risk and clients redeeming money from the fund. Whilst this is understandable charging fees for active management some 1% p.a. or 1.5% p.a. more than a passive fund tracking the index is not!
The few managers who consistently beat the market do so by having ‘high active share’ an academic term for holding a concentrated portfolio of stocks which bears no resemblance to a given index and therefore carries a higher market risk than that of a well-diversified index.
A study done by Standard and Poor’s, the giant US research company, found that over 15 years some 90% of equity mutual fund managers failed to beat the index. Over a shorter period 5 -10 years the figure reduces but still some 78% fail to beat the market. The way to guarantee as an investor that you will be in the top quartile of fund performance over the long term is to index. By that I mean, accept the market rate of return for a given amount of market risk for the lowest cost.
This philosophy requires the investor to allocate capital to ensure diversification of risk for a given amount of reward which is right for the investor and no one else. An active mutual fund manager must make market timing decisions and security selection decisions constantly to try and beat the market against which his or her performance is benchmarked. This is costly both in the additional cost of buying and selling securities and the increasing risk of being wrong or the manager making a losing trade. The market index against which the active manager is compared does not trade. Aware of just how hard it is to deliver a return in excess of a very low cost broad market index, investment managers and their firms often adopt an investment strategy which is very close to that held by the broad based market index which they are ultimately going to be compared to whilst still applying the fees associated with active management. Investors need to be aware of this and would do well to scrutinise security selection and asset allocation when selecting active mutual funds. Paying for what you do not receive is not a formula for investment success.
Jeremy Blatch TEP