According to research forthcoming in the Journal of Econometrics by David Blake, Tristan Caulfield, Christos Ioannidis and Ian Tonks, when ‘time effects and the non-normality of fund returns’ are considered, “there is no evidence that even the best performing fund managers can significantly out-perform the augmented benchmarks after fund management charges are taken into account.”
The research, which uses two new methodologies to improve the inferences that can be made when evaluating fund performance also found that fund size has a significant negative impact on performance.
Looking at the monthly return data for 561 open-ended UK domestic equity funds between the period January 1998 to September 2008, sourced from Lipper, Morningstar and Defaqto14, the researchers took account not only of the so-called ‘panel nature’ of the data set, but also the possibility of both time and fund effects on the nature of returns.
Apart from demonstrating that most managers are unable to beat the benchmark, Blake et al found that once fund size was accounted for “the average fund manager’s alpha for both gross and net returns is insignificantly different from zero”.
The researchers added: “This implies that if better qualified managers do manage the largest funds in the largest fund families – which is entirely plausible – they do not appear to deliver outperformance: in other words, the size of the fund overwhelms any superior skills they might have, as predicted by Berk and Green (2004)”.
In plainer English, even the so-called ‘star’ fund managers are unable to beat the benchmark because the size of their funds works against them.
Taking this point even further, Blake et al wrote: “Since the most likely explanation for the negative relationship between fund size and performance is the negative market impact effect from large funds attempting to trade in size (Keim and Madhavan, 1995), this suggests that funds should split themselves up when they get to a certain size in order to improve the return to investors.”
While the research and the methodologies are new, the findings are by no means ground breaking. That most active managers fail to beat the benchmark, is now widely accepted. That bigger funds tend to struggle to outperform is likewise fairly common knowledge.
What is perhaps more interesting is how this knowledge is slowly filtering down into the market place.
Speaking to the Financial Times, Blake was pessimistic that the market would change, despite people recognising that investors in the end seldom see a benefit. It is, indeed, unlikely that this research will see the demise of the active manager, no matter what the numbers show.
But, what you have already seen is that the market is no longer willing to pay as much for manager skill as it once was. And, while the data demonstrates that active managers do not always justify their fees, those fees have fallen a long way since 2008.
Head of financial planning at Hargreaves Lansdown, Danny Cox, agrees that the large majority of fund managers do not outperform the benchmark, but maintains there are some managers that have demonstrated over many years that they can outperform.
But, he added: “Costs in the active management space have come down much more than they have in the passive space, these days you can get an active fund for the same sort of fee passive funds were charging just a few months ago.”
Indeed, even the Neil Woodford, right now the starriest of star fund managers, whose new fund launches later this week has come to market at much lower rates than any would have imagined even a few years ago.
At the same time passive fund providers are being forced to drop their charges as well, especially if one can now get a manager like Woodford for .60% AMC.
The question now becomes, how much lower can the charges really go? And, importantly, will it be enough?