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Active vs passive management – funds and fees

Vanguard, known primarily for their passive fund range, recently announced that they would be launching a UK investment platform.

The platform will give investors the chance to buy and hold the Vanguard funds online and is much lower cost than some existing platforms such as Hargreaves Lansdown. It will obviously impact on current platforms which is one reason why Hargreaves shares fell sharply on the announcement.

The move will continue the active vs passive debate amongst investors.  Whilst some investors sit firmly on one side of the active-passive fence, we prefer to take a much more pragmatic approach. We look at the specific market, the active funds available and the underlying index being tracked. It would seem the introduction of the platform will make investing in the Vanguard funds cheaper, which will strengthen the passive argument that active managers can’t justify higher costs.

The cost of active management of investments within funds will typically always be greater than a passive index trackers. It will often require greater resources such as fund/portfolio managers, research costs for analysts and company visits and transaction costs to name a few.  The range of costs in the active space can be quite wide; in the UK All Companies sector (ex-passive trackers) there is a 2.45% pa difference in lowest to highest ongoing fund charge.  That’s some spread considering long term average for equity returns is c10%!  Table 1 details the cheapest and most expensive active funds in each equity region:

Table 1

Tabl1.PNG

Putting it to the test

Keeping with the passive vs active reasoning, can high cost active funds justify the additional charge compared to their lower cost active peers?

I’ve analysed some equity sectors, removing any index tracking funds and funds with less than five years history to see if there is any relationship.  I analysed the five costliest and five least costly funds in each sector and reviewed their average five year performance (after any management costs and fees have been deducted):

Table 2

Tabl2.PNG

It would seem that you can easily pay over the odds for an active fund. In each region the cheapest five beat the most expensive five, with the exception of the US sector.

Now it’s hard to believe the relationship (if there is one) is linear.  What about those in between?

Table 3 shows that in each sector the best five funds significantly outperformed the five cheapest funds. Similarly, the worst five funds are not the most costly.  It’s clear that the cost of investing in a fund alone cannot, and really should not, form the sole basis for rational investment decisions.

Table 3

Table3.PNG

Our fund research is extensive and relies on a robust and tested process combining quantitative and qualitative research.  We construct our portfolios by investing in what we consider the very best funds that we feel will complement one another to deliver strong returns on a risk adjusted basis.

Although not a primary focus in the fund selection process, we are mindful of fund costs that can, in more extreme circumstances, lead to us deciding against investment in particular funds.  We don’t mind paying higher active management fees where we can reasonably expect returns to compensate.  And it also goes without saying, where a fund has multiple unit classes we will always opt for the cheapest available class wherever possible.  

Of course, it is very hard to know in advance which active funds are going to outperform and which will underperform.  Mike’s investment newsletter from November 2016 explains how our sector screening process has helped us find outperforming funds which you can view here and this blog explains how we go about selecting funds - https://www.eqllp.co.uk/blog/pick-n-mix-how-we-select-funds/

I expect the introduction of the Vanguard platform will, in line with recent trends, put increased pressure on active managers to reduce fees.  Investors must see this as a positive with the obvious caveat that investment performance is not impacted. 

The content contained in this blog represents the opinions of Equilibrium investment management team. Past performance is never a guide to future performance. Investments may (will) fall as well as rise. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.