No, active funds haven’t outperformed. You must account for survivorship bias

Published on 22nd May, ‘Neil Woodford, Mark Barnett and the case for active management’ is an opinion piece by Merryn Somerset Webb, who is the editor of MoneyWeek magazine and an experienced financial journalist. Although we respect her work, we disagree with her argument that “the average UK active fund has outperformed over the long term”. In this blog, we’ll tackle her argument point by point.

“Research from BMO Global Asset Management last year showed the average active fund outperforming the average passive over 20 years, not just in the UK, but in Europe and Japan too.”

Examining the methodology of this study makes it clear that the study authors ignore a crucial issue, survivorship bias. This is the tendency to measure only those members of a group that survive to the end of the reporting period. In the world of funds, survivorship bias can cause highly skewed results.

That’s because most funds don’t survive as long as 20 years. In fact, only the most successful do, because funds that underperform are likely to close or go bust. A study by ratings agency S&P found that survivorship of UK equity funds after ten years is just 46%. That means more than half of UK equity funds don’t survive for ten years, let alone 20.

Any study of fund performance over the long term is likely to reach the wrong conclusions if it doesn’t account for survivorship bias. The study by BMO Global Asset Management does not appear to have been published in a peer-reviewed journal. It’s worth mentioning that the firm’s multi-manager team, which produced the study, invest heavily in active funds. Although the team does include passive funds in their portfolios, only about 15% of the portfolios’ exposure is passive².

“It isn’t true of the US, where most studies into this kind of thing are done, presumably because performance there is led by a few huge tech companies (now more than ever). There, winners take all – and the winners dominate every tracker.”

The study mentioned above found that the US was an exception. The authors seemingly could not find evidence that the average active US fund outperformed the average passive fund over 20 years. But is the US so exceptional?

Ratings agency S&P produces comprehensive comparisons of active funds with passive indices. These are called the SPIVA scorecards. In the US over the last three and five years, 71% and 80% of large cap equity funds underperformed the main index. In Europe, the comparable figures are 79% and 77%. In the UK, the figures are 56% and 68%.

Merryn Somerset Webb’s idea that some of the mega technology stocks in the US make it difficult for active managers to outperform is potentially true, but we see a similar level of underperformance in both the UK and Europe where there is no Microsoft or Amazon dominating the index.

“But back to the UK. The real point to bear in mind here is that the average active fund has outperformed over the long term. Your job, then, as a UK investor with the idea of beating the index a little, is to make sure that the returns on your holdings add up to at least the average of the UK active fund sector. That in turn could mean little more than avoiding holding the worst funds in it.”

Again, this argument fails to account for survivorship bias. What Webb makes sound easy is in fact hard, because the UK investor in her example does not have to avoid only the worst funds in the active fund sector, the investor also has to avoid all the funds that will fail to survive to the end of the reporting period. The investor is being asked to pick “the best of the best”, in advance, in an environment in which more than half of UK equity funds are closed within ten years.

Remember the losers, not just the survivors

Webb’s article begins by discussing Neil Woodford and Mark Barnett, two fund managers whose funds suffered exceptionally poor performance in recent years. The ironic thing is that these examples of spectacular underperformance are exactly what is missed by studies that fail to account for survivorship bias. Funds such as Woodford’s or Barnett’s are the ones that tend to be closed, therefore they disappear from any analyses that don’t take into account survivorship bias. If you are not careful, the history of active funds tends to be written by the survivors – in other words, by the winners – and the losers get forgotten.

In conclusion, we still think passive ETFs have many advantages

At Nutmeg, we have always said that there are some great managers who have outperformed over time and generated highly attractive returns for their clients. But it seems hazardous to us to say that the average UK manager has outperformed over 20 years using a partial study that seems to overlook one of the most well documented biases. Studies from S&P seem to us more representative of the reality of performance for the UK stock picking industry.

If you’d like to read more on this topic, we’ve explained before why we think passive investments are preferable to active ones. We’ve also written about why we prefer ETFs to active mutual funds.

Sources

1. There are other biases that should be taken into account when measuring fund performance. It is not clear whether these biases were accounted for in the study mentioned, for example:
   1. Size bias. Generating good excess return is often easier on a smaller scale. Some large UK funds that have attracted a lot of new assets might struggle to repeat their past good excess return;
   2. Backfilling bias. This is the bias of reporting fund performance to Lipper and other database providers only when performance has been good.
2. Data on percentage of passive exposure in BMO Multi-Manager portfolios taken from BMO Multi-Manager PassiveWatch report, 2019.

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 performance is not a reliable indicator of future performance.