It’s finally happened. For the first time in 26 years, and only the second time in Premier League history, all three promoted teams have been relegated the following season. Such is the quality of England’s top division that simply surviving is a considerable achievement.
It’s a similar story in active fund management. There are more professional investors around the world competing with one another than there have ever been. Added to that, they have access to more information than at any time in the past, and the technological resources at their disposal continue to improve, year after year. Is it any wonder that genuine and consistent outperformance is as rare as it is, or that funds come and go at such a remarkable rate as they do today?
A crucial point that many investors fail to grasp is quite how many funds there are to choose from. According to one estimate, there are currently around 19,625 listed investment funds worldwide. (1) A few years ago it was the growing demand for sustainable investments that was driving product innovation; nowadays it’s artificial intelligence. Asset managers are increasingly using AI technologies, not only to make their operations more efficient but also to help devise and implement new investment strategies.
Survival rates are low
Despite such innovation, new funds are struggling to survive. According to the Global Asset Management Report 2024 from Boston Consulting Group, only 37% of all mutual funds launched in 2013 still existed by 2023. (2) This is a significant decrease compared with 2010 when 60% of funds that had been launched a decade earlier were still in operation.
It’s extraordinary to think that if you bought a newly launched fund in 2013, which is not exactly an age away, the strong likelihood is that it would have ceased to exist in its own right within ten years. And remember, asset management companies don’t decide to close a fund or merge it with another one if its performance has been strong. In most cases, funds are closed or merged because their relative returns have been so poor that fund houses want to expunge that poor performance from the records.
But what about funds that do manage to survive? How likely are they to outperform? Unfortunately, the evidence is very discouraging. As scorecards like SPIVA from S&P Dow Jones Indices or the Active/ Passive Barometer from Morningstar consistently show us, most active managers underperform for most of the time. (3,4) On a properly cost- and risk-adjusted basis, only a small proportion of funds success in beating the appropriate benchmark over ten years, let alone the 30 or 40 years or more that people tend to invest for.
That’s not to say that genuine skill does not exist in active fund management. The point is that it’s very hard to distinguish skill from luck, and identifying a star performer in advance is exceedingly hard.
Outperformance is generally fleeting
The mistake that many investors make is that they decide to invest in a particular fund after a period of strong performance. The problem with that is that outperformance tends to come in short bursts and is usually followed by a period of underperformance. As Vanguard founder Jack Bogle once said, “reversion to the mean is the iron rule of the financial markets.”
Let’s say, for instance, that a fund manager outperforms for a few years and their success is genuinely down to skill, rather than luck. It would be reasonable to expect that outperformance to persist. But, in practice, how often does that happen? Well, part of the ongoing SPIVA analysis is a Persistence Scorecard, which is designed to measure the consistency with which active funds deliver market-beating returns. What the scorecard shows is that, regardless of asset class or style focus, outperformance is typically relatively short-lived, with few funds outranking their peers on a consistent basis.
Take, for example, the latest Persistence Scorecard for Europe, which includes the UK. In five of the six equity fund categories analysed and all four of the fixed-income categories, not a single manager whose performance placed them in the top quartile for the 12-month period ending December 2019 managed to remain in the top quartile for the next four years. (5) It’s rather like Manchester City or Liverpool winning the Premier League quartile and then finishing no higher than sixth for the next four seasons.
The same research also shows that, over the long term, poor performance has been a reliable indicator of future fund closures. Across the ten categories analysed, an unweighted average of 36% of active funds whose performance placed them in the bottom quartile in the five years ending December 2018 were subsequently closed or merged over the next five years. The comparable figure for funds in the top quartile was just 18%.
The logical alternative
So anyone planning to invest today in an active fund should do so with their eyes wide open. There is a very real chance that, whichever fund you choose, will perform so poorly that it will cease to exist by 2034. Yes, you could opt to invest in one of today’s top-performing funds, but, if you do, it’s very unlikely that it will carry on producing top-quartile performance for more than a few years.
The logical alternative is to invest in index funds instead. Index funds are not designed to produce top-quartile returns in the short term. But, as long as you’re disciplined enough to stay invested, they will almost certainly produce top-quartile returns, after costs, in the very long term. What’s more, they are far more likely to survive than their active counterparts.
Do you want to aim for stellar returns even though the odds are stacked against you? Or would you rather capture the market return and maximise your chances of a successful investment outcome? The choice is yours.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products.
Robin Powell is a journalist, author and editor of The Evidence-Based Investor.
References:
- https://www.bcg.com/publications/2024/ai-next-wave-of-transformation
- https://www.bcg.com/publications/2024/ai-next-wave-of-transformation
- https://www.spglobal.com/spdji/en/research-insights/spiva/
- https://www.morningstar.com/en-uk/lp/european-active-passive-barometer
- https://www.spglobal.com/spdji/en/spiva/article/europe-persistence-scorecard/
