The majority of active fund managers have not managed to beat the market in recent years. Several of those calling themselves active investors – and being paid well for it – are quite simply no more than closet index investors. In other words, they choose to have a little more, about the same or a little less of a stock/sector/country included in the index. There is only a very slight chance that so-called index huggers, or closet index funds, are able to beat the index after their high costs are deducted.
So why don't all active managers manage clients' assets in a "truly active" manner?
One explanation is the fluctuations. If your fund is active – i.e. almost entirely different to the index – it goes without saying that it will move out of step with the index from year to year. Some years the fund will perform significantly better than the index, and some years significantly worse. The goal is to do significantly better than the market over time. Studies have shown that investors often pull their money out of funds with large fluctuations. This is clearly not positive for the profitability of a fund management company and can result in a manager replicating the index too closely.
Most funds are owned by large banks or insurance companies and they lay down strict guidelines regarding how different they dare to be in order to retain clients' assets and protect their own reputation.
Another explanation is portfolio managers' fear of losing their job if they perform extremely poorly one year. You have a greater chance of keeping your job if you do just slightly worse than the index. Hence, portfolio managers may be tempted to invest very similarly to the index.
Other challenges
There are other challenges, however. The most important of these is the expansive and unconventional monetary policy that has been pursued since the financial crisis. This has resulted in pushing up the valuation of everything, be it stocks, property, bonds, etc. We are in a period of high tide, which has buoyed all boats, regardless of quality. In October, the US magazine Forbes painted a good picture of the challenge faced by the world's active managers; they see active management as akin to collecting shells on a beach, an activity which is definitely best done at low tide.
Nevertheless, high tides do not last forever. The US central bank, the Federal Reserve, will cautiously hike the policy rate, most likely starting in December. The period of ultra-low interest rates and marginal market fluctuations may therefore be drawing to a close.
In August 1979, Businessweek proclaimed the end for equities – right before the most protracted and strongest rally ever. Last month, Wall Street Journal wrote on their front page that stock picking is a dying business.
Own worst enemy
In a purely passive and indexed world, it is immaterial whether a company is good or bad. The only thing that has any impact is the weighting in the respective indices while the companies' fundamental value development is irrelevant. All in all, such a passive world would create and reinforce mispricing in the market. Index investing is therefore its own worst enemy and creates fertile conditions for "truly" active investors. And when the central banks hike interest rates again, it will be beneficial to have active managers to pick stocks that are mispriced and provide downside protection for fund investors. That is when truly active management will again prove to be the better alternative.