With hindsight, we could have produced better results by choosing a top performing active manager. The trouble is, we cannot choose funds with the benefit of hindsight. We are not aware whether this year’s top performing fund will be among the best performers in the future. We are however, reasonably confident that passive funds will produce better than market average returns over a five to 10-year period.
Perhaps more of a concern than absolute fund performance is the variance in volatility of active funds. Looking once again at the UK market, over the past 10 years, it would have been easy to unwittingly pick a fund which was up to 20 per cent more volatile than the L&G UK Index Trust. When thinking about robust portfolio construction techniques, is this the sort of risk we should be taking with our clients' portfolios?
Probably not
One response to my comments above may be to say that it is no surprise to see passive funds outperforming in the UK equity sector. Perceived wisdom may say that this is not an unexpected result, since it is difficult to outperform in mature, highly liquid markets. Perhaps we should just take a moment to see whether active funds fair better in, say, the emerging markets sector? Surely an active manager should be able to add value in a less efficient market place such as this? While this is indeed possible it is a relatively unlikely outcome. The average emerging market equity fund grew 82 per cent in the last decade, while the MSCI Emerging Markets index grew 97 per cent.
In each of the main equity sectors, we are able to access passive funds which produce performance that is very close to that of the index, and outperform the sector average. It is also striking to observe just how wide the variance of volatility is across the funds available. One should bear this in mind when choosing an active fund to populate a portfolio with a pre determined risk level.
Surely a more effective way to do this is to conservatively manage a portfolio of passive funds where you know that your asset allocation will be as accurate as possible with no risk of drift. While the major benefit of such a strategy is the perfect replication of the desired asset allocation, there is of course the welcome by-product of low cost and therefore higher than market average returns.
This is borne out by the performance we have generated through a range of risk-graded model portfolios. At each level of risk, we have been able to generate superior returns, with less volatility than the respective RTMA (Risk Targeted Multi Asset) sector average performance levels.
