Most active funds are priced to fail

Posted by Robin Powell on January 3, 2017

The whole point of hiring a consultant is to add value over and above the price you pay for them. So, for example, you pay £1,000 in the hope of reaping, say, £5,000 or £10,000 of value.

Surely no one in their right mind would hire a consultant when the value they’re likely to add is less than the fee they command? That, however, is precisely what investors are doing when they choose to invest in actively managed funds.

An active manager is like a consultant. You hire them to deliver a return greater than what you could expect by simply investing in a low-cost index fund.

But new research by Morningstar shows that the potential excess returns, before fees, of most US equity funds are smaller than the fees and charges that people pay to invest in them.

In a nutshell, this is what researchers found:

  • – average pre-fee excess returns of most US stock categories have fallen in recent years and are now well below the long-term average;
  • – fees have not fallen as steeply and, thus, more than two-thirds of US equity funds levy expenses that would wipe out their estimated future excess returns before costs;
  • – of the funds that charge less than their estimated pre-fee excess returns, many have little margin for error (i.e. their fees are no more than 0.30% below potential future excess returns before fees); and
  • – fund over-pricing is particularly widespread among US large-cap funds.

In conclusion, Morningstar’s Global Director of Manager Research Jeffrey Ptak said:

“Many active US stock funds are too expensive to succeed. This is especially true of US large-cap funds, the clear majority of which charge well more than our estimates of potential future pre-fee excess returns.

“All told, it appears that overpriced active US equity funds (i.e., those whose fees exceed likely future excess returns) still hold nearly $2 trillion in assets, and there’s little margin for error among funds that are less expensive.”

Interestingly, Morningstar admits that its figures are conservative; in other words, the real picture for active investors could be even worse. That’s because, in their calculations, the researchers “grossed up recent excess returns to allow for the possibility that those recent figures were depressed by fleeting factors”.

This, of course, is an extraordinary state of affairs. Whether they realise it or not, investors in active funds are, in most cases, paying to have value extracted rather than added.

It’s also worth remembering that the United States has the lowest fees for active management in the world. The value extracted by active managers in every other country is therefore even greater.

So, what are the implications of these findings for the active fund industry? That’s the question we’ll be asking in our next post.

Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.

Read more...

How can tebi help you?