What went wrong with active management?

Fund research

There is no hiding the fact that market conditions over the last 18 months have proved difficult for actively managed funds. If we take the IMA All Companies Peer Group as a crude proxy for the actively managed UK equity funds, they have underperformed tracker funds by about 8% over this period. Quite rightly, investors are asking themselves why has this happened; and is the case for actively managed funds permanently broken?

From a historical perspective, actively managed funds have tended to do better when market volatility has been low and economic conditions relatively benign — the two generally go hand in hand.These periods coincide with times when an overweight to smaller companies and a focus on company fundamentals, as opposed to the macro economic backdrop, have been better rewarded.

When the reverse is the case, i.e.,higher market volatility and a more uncertain economic outlook, the opposite applies. In this environment, larger companies with stronger balance sheets tend to outperform, and more top down or macro-driven decisions can start to play a more important contribution to the success of a fund.

With the benefit of hindsight it is now clear that we have been in this environment for about 18 months. A further issue has been the impact of deleveraging of hedge funds. This has led to forced selling of assets, driving down prices severely in cases where liquidity is poor, e.g. smaller companies.

Broadly speaking, we believe the performance of actively managed funds tends to be cyclical. But on this occasion the cycle has been much more violent given the stresses experienced in the financial system and, consequently, managers caught with poorly-positioned portfolios have been hurt all the more. Amongst these have been a number of highly rated managers, who have gone into this bear market with either an overweight to smaller companies, high exposure to more cyclical companies or companies with highly leveraged balance sheets — in some cases a combination of all three. The impact of these portfolio positions has in turn been compounded by a lack of liquidity in some underlying holdings, entrenched views, and fund redemptions culminating in some very poor results. Axa Framlington Equity Income and Monthly Income, New Star UK Growth and Higher Income, Gartmore UK Focus and Legg Mason US Equity are but a few of the previously popular, high profile funds that have lost their shine. Funds that adopt a more systematic or quantitative approach to investing have not escaped either, as evidenced by Artemis European whose investment approach is built around a proprietary stock picking model; whilst the designers of this fund style have always pointed out that they will tend to struggle at market inflexion points, the extent of the underperformance has still caught investors by surprise.

Currently, we are of the view that it is likely to remain a macro environment for some time — one that favours defensive blue chip companies, with strong balance sheets and ability to grow dividends. Funds that we believe currently exhibit these characteristics include Invesco Perpetual Income, Rensburg UK Equity Income, Artemis Income and Cazenove European. We would also include large cap index tracker funds amongst this list, such as Legal and General UK Index. Although smaller companies might appear cheap, we believe more evidence is needed that credit markets are starting to normalise before we might countenance such a move down the scale. Whilst corporate bond spreads are elevated and yields appear to have stabilised, we are not there yet.

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