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There is a battle raging in the fund management industry. Active fund managers, those that pick individual securities in an aim to beat the market [1], like the UK stock market, are at war with the ‘passive’ fund industry. Passive funds use rules-based systems to invest, such as weighting the amount held in each company based on its size, usually at an incredibly low cost. In recent years, money has been flowing out of active funds and into passive funds, nevertheless the amount of money held in active funds is still many times greater than in passive funds – about seven times greater in the UK retail fund industry for instance [2].

Supporters of stock picking and active funds in general, say that just getting the return from the market is defeatist and a guarantee you will underperform after costs. So, for all the claims from supporters of active funds that you can beat the market listed below, how does the evidence stack up?

1. Active funds outperform the market

Standard & Poor’s (S&P) conducts an annual study of active US mutual funds. According to this research [3], only 18.5% of active US equity managers [4] have beaten the market over the past three years, 11.9% over five years, 15.5% over 10 years and 8.4% over 15 years. In other words, you had about an 85% chance of holding a poorly performing actively managed fund over 10 years.

In S&P’s analysis for the UK market, over the 10-years ending December 2018 only 26.5% of active managers beat the UK stock market. Over the past three years the figure is just 19.7% – so four out of every five managers failed to beat the market [5].

2. Active funds outperform in markets that are less researched and less efficient, like small companies and emerging markets

The US equity market is largely regarded as the hardest to beat, but what about less researched areas like small companies and emerging markets? Well, the same S&P research shows that over the past five years respectively 89.4% and 92.7% of US small-company and emerging market active fund managers failed to beat their benchmarks. Over 10 years the figures are 85.7% and 87.7%. Thus, the data does not back up the claim that active stock pickers do better in less researched areas of equity markets.

3. Some asset classes can only be accessed by active managers

We agree with this in principle, but not to the extent industry opinion suggests. In fact, we believe that this particular type of asset classes such as frontier equity markets (beyond the established 23 emerging markets), convertible bonds, leveraged loans and commercial property are not very suitable for investing via passive funds, like exchange-traded-funds (ETFs). But these asset classes make up a tiny proportion of the universe of investments available and in the case of commercial property, we have concerns about any fund investing in this asset class offering daily or even monthly liquidity.

However, in assets like emerging market debt and high yield – which used to be considered only accessible by active managers – ETFs have become a very easy way to access these asset classes. They are very efficient, cheap and easy to trade – and often held in active managers’ funds.

4. Active funds do better in down markets

If we look back to the financial crisis in 2008, the average active manager did not beat the UK equity market. The FTSE All-share returned -29.6% including dividends, whereas the average UK equity fund returned -31.0%. And when we look at the market more broadly, 59% of UK fund managers failed to beat the market that year [6].

In fact, active managers did better in the rebound in equity markets in 2009, rather than in the sharp decline in 2008. The average active manager returned 31.5%, slightly ahead of the 30.7% return for the market. For 2008 and 2009 combined, the average return for active UK equity managers was -9.86% versus a return of -8.71% for the FTSE All Share.

Moreover, if at the start of 2009 you picked a manager that had performed very well in 2008, performance would have been disappointing. Looking at the best performing ‘top-quartile’ (25%) of managers in 2008, only 49% of these managers beat the market over the next three years (2009-2011).

5. While the average manager under-performs, you can pick an active fund that will do better in the future

Standard and Poor’s looks regularly at the persistence of top-performers [7]. Examining consistently top performing funds in US equities, it took the top 25% (563 funds) in September 2015 and analysed their future performance. In just two years (September 2017) only 6% of these funds were still top-performers.

Within the same report, S&P also looked at top performing funds over a longer time period, taking the top 25% of funds over five years to September 2012. In the five years to September 2017 only 25.3% of these funds were still in the top quartile. Similarly, of the funds that were better than average in the five years to September 2012, only 45% were better than average in the next five years. In other words, past performance alone is a poor indicator of future performance.

Many firms provide services to assess potential future performance based on a broader set of criteria than just past performance and then provide a rating for active funds. One of the largest, and most deeply resourced, global firms is Morningstar. Its own research shows that the future performance of funds rated five stars is only modestly better compared to three-star funds [8]. According to a study by the Wall Street Journal on Morningstar ratings [9] “of funds awarded a coveted five-star overall rating, only 12% did well enough over the next five years to earn a top rating for that period; 10% performed so poorly they were branded with a rock-bottom one-star rating”. In fact, rather than a star rating, low fees are the best guide to future outperformance: “the expense ratio is the most proven predictor of future fund returns” says Morningstar [10].

6. This year is going to be the year when active funds outperform

Hope springs eternal. The best year for active managers in the past decade was in 2009, when 59.3% beat the market. Typically, when markets are volatile and there is a wide dispersion between the performance of different sectors and company shares, then active funds are expected to outperform.

In our view, the under or outperformance of active stock pickers is often highly related to the performance of small companies versus large ones, rather than just the performance of individual companies. In our analysis of UK active fund returns we show that 95% of the time, in the quarters when active managers outperform the UK market, small companies had outperformed large companies.

That the typical stock picker over-weights smaller companies makes sense. Given the dominance of very large companies in the market, to take an active position requires moving away from these large companies – or alternatively being even more concentrated in a few companies, reducing diversification. In the UK, the top 10 companies account for 36% of the broad UK market, out of 637 stocks (FTSE All-Share universe). So, overweighting a company outside of the top ten is always a decision to overweight smaller companies and underweight large companies. In our opinion, this an asset allocation decision.

At Nutmeg, rather than dedicating huge resources to trying to find stock-pickers who will perform in the future – in what we think would be a fruitless task – we focus on asset allocation as the key driver of investment performance. We use passive funds to deliver the return of each asset class with precision and at very low cost, while focusing on the bigger factors – like economic growth and interest rates – that drive all markets.


[1] We focus here on active managers, seeking to add value through stock selection, rather than active asset allocation, where managers primarily use a tactical approach to asset allocation to add value rather than bottom-up security selection

[2] Based on statistics from the Investment Association, passive funds made up 15.7% of retail fund assets at the end of 2018

[3] S&P Dow Jones, SPIVA US Scorecard 2018

[4] SPIVA, ‘All domestic funds’

[5] S&P Dow Jones Indices, SPIVA Europe Scorecard Year-End 2018,

[6] Our analysis based on data from Bloomberg and Morningstar, using IA UK All Companies sector primary share classes and total returns in GBP

[7] S&P Dow Jones, January 2018: “Does Past Performance Matter? The Persistence Scorecard”

[8] Morningstar, November 2016: “Analyzing the Performance of the Star Rating Globally”

[9] The Morningstar Mirage


Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.