Secrets Of Success: Be active only when the time is right

Searching through the performance figures of the unit trust business, as I do on a regular basis, provides an opportunity for an update on the relative performance of actively and passively managed funds. It is reassuring to be able to report that for any medium-term investor, normal service is being resumed, in the sense that the temporary and abnormal period of excess returns to active management appears to have come to an end, at least for the time being.

The table below shows how the figures look for periods of one, three and five years. The data I have used comes from Citywire, the online share and fund information service.

The data is based on total returns on a bid-to-bid basis (which slightly flatters the performance of actively managed funds, since it does not account for the cost of investors attempting to realise the value of their fund holdings). The data covers the All Companies sector, the largest of the UK equity sectors.

If one takes the data for the FTSE All-Share index, which is the normal broad market measure used by investors, it shows that of 224 surviving funds with five-year records, 80 (or 35 per cent, just over one in three) can claim to have outperformed the market in that time.

Since several of the worst-performing funds over the past three years will have been either closed or absorbed into other funds, it is a safe assumption that the ex ante proportion of funds that have outperformed the market since August 2000 is actually smaller than this figure.

If you calculate the figures for three years, they show that 114 out of 271 surviving funds with three-year track records (about 42 per cent) outperformed the FTSE All-Share index.

Over the past 12 months, a mere 57 funds (slightly less than one in five of the 314 funds operating over that period) achieved the same feat. In other words, the last year has been a relatively good one for index funds, as evidenced by the fact that the proportion of actively managed funds that outperform has reverted to something near its typical long run level (around 30 to 40 per cent).

The main reason why actively managed funds have until recently been enjoying an above-average run begins to emerge if you study comparable figures for performance of funds against the FTSE 100 index, as opposed to the All-Share index. As the FTSE 100 has underperformed the broader market index for part of the past five-year period, reflecting the strong performance of smaller company shares, the number of active funds doing better than the Footsie is higher than the equivalent for the All-Share index.

For example, over the past three years, a clear majority of funds (167 out of 271) outperformed the Footsie index, while over one and five years, the figures are 20 per cent and 50 per cent respectively. This tells us that the middle years of the period saw a strong performance by small companies relative to large ones, but that this has started to reverse. A strong performance by smaller company shares helps the performance of actively managed funds, for the simple, important reason that the majority of actively managed funds invest primarily in the lower reaches of the market capitalisation scale.

As with all data about investment performance, it is important to draw the right conclusions from these numbers. The first is that the data does not invalidate the general proposition that index funds will reliably deliver second-quartile performance (that is, beat the majority of actively managed funds) over any medium- to long-term horizon.

When I say that the latest figures are reassuring, it is because they once again underscore this important long-term truth.

The reason they will do so is ultimately because of the higher charges that actively managed funds impose. The latest data also, in passing, reinforces the well-documented truth that fund managers who can beat the market consistently over different phases of the market cycle are very rare birds indeed (though those who can are rightly worth looking for, as the rewards can justify the effort).

At the same time, however, it is evident that index funds will only reliably achieve predictable second-quartile performance in the medium- to longer-term. In any one period, there will always be actively managed funds that comfortably outperform the market.

The important thing to realise, however, is that in most cases this will have little to do with the skill of the fund manager. Funds that display the style bias (say, small cap versus large cap) that is currently being rewarded by the market will be the ones that do best.

No general conclusions about the merits of active versus passive management (for or against) can, therefore, be drawn from specific period data. There are periods when active management will do better and periods when it will do worse.

Where I disagree with the FSA and other regulators, who seem to believe that active management is never worth the candle, is in thinking that these periods are ones that can, on occasions, be predicted with some confidence.

For example, it is generally the case that small cap stocks - and hence the majority of actively managed funds - tend to outperform when bear markets end. If you think you can tell when a bear market is coming to an end, as many commentators did in 2003, you should be able to draw a fairly reliable inference that it is a good moment to give your portfolio more of an actively managed bias. This has turned out to be the case.

By the same token, it is as near a certainty as anything is in investment that we will have another period of large cap dominance before too long. That will be a good moment to have shed your actively managed small cap stocks in favour of index funds and funds with a larger capitalisation bias.

Whether or not you choose to opt for actively managed funds in these cases will ultimately depend on what level of knowledge and skill you can bring to this decision.

As Warren Buffett likes to say, the real risk in investment is not measured by volatility or any other mathematical formulae. The real risk in investing is not knowing what you are doing.

Once you start to think of actively managed funds as primarily instruments that allow you to benefit from different phases of the market cycle, rather than as pure plays on the skills of a particular fund manager, the nearer you will be to finding the right balance in your investments.

If you get those calls right, you can do very well indeed, as a handful of funds will not only outperform in those circumstances, but they will do so by a handsome margin.

jd@intelligent-investor.co.uk