nottheaverageactuary

Actuarial news and views from Cape Town and beyond

Are active funds becoming obsolete?

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Active funds aim to outperform the market and generate higher returns by using intensive techniques such as data analysis, stock picking and short sell to achieve this, but according to recent statistics, it seems most of them failed to achieve their target despite their best efforts. There are plenty of statistics to show this, I give two graphs here as examples:23

In contrary to active funds, passive funds simply diversify their assets to track the market and earn the market rate of return. Therefore the funds that failed to beat the market also failed to beat the passive funds. It seems counter-intuitive that these simple funds were able to outperform the more sophisticated active funds, but economics theories such as Efficient Market Hypothesis have argued that the market is not predictable and no technique can help funds systematically outperform the market. Other economic theories have attacked the theoretical foundation of the active funds. For example, the Capital Market Pricing Model argued that all investors should hold the market portfolio (which is what most passive funds aim to hold) instead of picking stocks.

The reason why the active funds are performing so badly may be the economic conditions, unsound management or simply bad luck. But besides these generic reasons, the high expenses of running active funds might have a particular impact on the level of returns they were able to deliver.

The complex techniques and strategies deployed by active funds are all very costly. In addition, active fund managers also charge very high management fees. For example, hedge funds often have a “2&20” fee structure, which means 2% of total assets as management fee and 20% of any profits as performance fee. On the other hand the fees can be as low as 0.06% for some passive funds. State Street’s huge Spider fund, which tracks the S&P 500 index, charges only 0.09%. While the fees made many fund managers wealthy, in the long run such a 40-year period, they will greatly reduce the returns:

fund-returns-over-the-years

Assuming 10% return and various fee levels

The high fees the active funds charged allowed them to pay much higher commissions than passive funds to financial advisors to promote sales. That’s why historically active funds have been the dominant investment choice. However, as they fail to deliver results, monies are flowing out of active funds into passive funds and as a result active funds are gradually losing market share to passive funds:

Screen-Shot-2013-04-02-at-9.58.34-AM-1024x682 (1)

passive-vs-active

As you can see passive funds are not dominant yet at 26% but are becoming the mainstream approach.

Despite unsatisfactory performance in general, active funds still have some superiorities. As we have seen, not 100% of active funds fail to outperform and over the past two centuries there had been a number of star fund managers and investors who were able to beat the market for extended periods of time, although at the same time millions of other investors were not as fortunate.

9

The decreasing sale is also forcing active funds to change. Last year a no-fee hedge fund was launched in the United States in November last year. This fund did not charge a performance fee, but only a 1.25% management fee. It has achieved a 10% return as of about August, which is solid performance as most other active funds in the same category were losing money.

Therefore, although active funds may continue to underperform and see a contraction in market share, they are not likely to disappear. But, unless active funds have a radical reformation, passive funds would still be better a choice than active funds for the majority of investors for their low costs and guaranteed performance.

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2 thoughts on “Are active funds becoming obsolete?

  1. I’ll kick off the active-passive debate with two classics:

    1. If Active funds DO become obsolete, what will happen to the market? Who will trade?

    2. If I want to take on more risk for more return, can I do that using passive funds or do I have to invest actively?

  2. 1. Well they probably won’t really disappear. It is getting obsolete given its current structure e.g. high costs. If things get really bad for active funds they can just change and survive. Last year the average annual earning of the top 5 hedge fund managers was $2.5 billion. Considering the huge amount of money the managers take, I think there is plenty of room for improvement.

    2. Certainly active funds will be more advantageous as they have much more freedom over their investment portfolios. However passive funds track different indices and carry the risks associated with these indices. There are many indices to track and they must have different levels of risk. Therefore it may also be possible for passive funds to increase risk and return, although to a limited extent.

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