I’m not against active management as a matter of principle. As soon as there’s an active fund that’s worth investing in, I’ll be only too happy to say so. But I’m not hopeful I’ll be able to do so any time soon.
The main reason is that, as things stand today, the active fund industry is completely unfit for purpose. There are far too many funds, charging far too much and providing too little value, if any at all, in return. Of course, we may see an improvement but, to quote Anthony Hilton in the Evening Standard yesterday, “inertia is almost guaranteed because so much is entrenched, there is so much self-interest and so many people have a vested interest in the status quo”.
There is, however, another reason why I’m distinctly pessimistic about the future of active management. That is that the alternative — passive investing in all its forms — will actually get better and better. Indexing.
I’ve mentioned in the past, for example, the potential for equal-weight index funds, as opposed to cap-weighted funds, which are pretty much the industry standard. But there is another, related option that may prove even more effective, and that’s equal sector (ES) weights — in other words building a stock portfolio that equally weights each sector of the economy.
Earlier this year, Aneel Keswani from Cass Business School, and David Stolin and Maxim Zagonov from Toulouse Business School, published a study into how an equal-sector UK equity portfolio would have performed since 1987, the year that sector indices first became available. Their remarkable conclusion was that an ES portfolio would have trounced active managers:
“We find that since ES has outperformed every single fund by some performance measures, and the vast majority of funds by any measure.”
So, how can this outperformance be explained?
“The intuition for our finding is that equal-weighting, as a trivial form of fundamental indexing, breaks the link between portfolio weights and market values, reducing the exposure of the portfolio to over-valued assets and increasing its exposure to under-valued ones (Booth and Fama 1982, Hsu 2006, Hanke and Quigley 2014). This results in enhanced portfolio returns.”
In conclusion, the authors say this:
“While choosing an active mutual fund over the value-weighted index in the face of the evidence requires a measure of conviction, choosing an active fund over the equal-sector strategy requires a rather more impressive leap of faith.
“Our results significantly increase the burden of proof on active equity fund managers wishing to convince investors that they can outperform passive strategies, and introduce an easy to implement passive alternative for would-be investors in such funds.”
There’s already a large number of sector ETFs available in the US, and I’m sure it’s only a matter of time before there are sector ETFs for the UK and other European countries too. When that happens it will become even harder to justify the use of actively managed funds than it is at the moment.
Active managers, therefore, had better get their act together. In the coming years, investors are going to be able to capture market returns more cheaply and efficiently than ever before. Sorry guys, but in the words of the late Ronald Reagan, you ain’t nothing yet.