Active fund performance isn’t necessarily the problem

This piece isn’t about active vs. passive. But, for what it’s worth, we don’t believe investors should view it as ‘one or the other’. Instead, you should be open to utilising both as to dismiss one entirely would limit your toolkit for managing portfolios, and why would you want to do that? Indeed, whilst in most sectors active funds on average underperform, there are still some (such as small-cap equities or pockets of credit) where they outperform.

Very often we read about active vs. passive and active fund underperformance, but we rarely discuss a separate, crucial point: investors’ actual returns are also shaped by the timing of their decisions to buy/sell funds. One way to outperform is by managing to select an active fund that outperforms. However, another way is to identify when certain styles of funds outperform in certain environments, and time your trading so that you are buying/selling funds in line with this approach. Unfortunately, this is a very hard skill.

"Mind the Gap"

Morningstar’s “Mind the Gap” study captures this reality clearly. By comparing a fund’s total return with the returns actually experienced by investors (based on timing of inflows and outflows), the analysis reveals a persistent shortfall.

The Morningstar analysis is incorporates 20,000 (active and passive) fund share classes of US mutual funds and ETFs, accounting for approximately $21 trillion. What the analysis shows is that investor returns were -1.1% per annum below fund returns over the ten-year period to December 2023.

This gap suggests that poor timing is a real issue and is detracting from investor outcomes.

Observing asset flow data helps explains the gap

So why does this happen? The answer lies in behavioural biases and return-chasing behaviour. When performance is strong, investors pile in. When it falters, they start to sell out – effectively ‘buy high, sell low’.

You can see this in practice below, where we show the relationship of a well-known equity fund between net flows and active return (i.e. relative return to the benchmark). As the fund outperforms the benchmark, net flows then increase, and vice versa.

This is paramount when assessing MPS providers

If you're outsourcing investment management to MPS providers, it's vital to dig deeper than high level performance numbers alone. Are your providers adding value through fund selection – not just in choosing funds, but in when they buy/sell them?

That’s why we’ve built an analytical framework to assess exactly this. It measures:

• How the underlying funds in an MPS perform versus benchmarks, and

• Whether the timing of those fund selection changes adds or detracts from performance.

In today’s Consumer Duty environment, advisers must evidence that their recommended solutions deliver value for money. Understanding whether your MPS partners are truly skilled at fund selection and timing should be a core part of that assessment.

DISCLAIMERS

This is for informational purposes only and does not constitute investment advice. This does not constitute an offer or solicitation to buy or sell any financial instruments or to participate in any particular trading strategy. The information contained herein is believed to be accurate at the time of publication, but no warranty is given as to its accuracy or completeness. Past performance is not indicative of future results. The value of investments and the income derived from them can go down as well as up. Investing in financial markets involves risk, including the possible loss of principal. Investors should consider their own risk tolerance and investment objectives. This document is intended for use by professional investors and financial advisers only and is not intended for retail clients. Any opinions or views expressed in this are those of the author and are subject to change without notice. This complies with the regulations and guidelines set forth by the Financial Conduct Authority (FCA).