Only a third of fund managers beat a cheap tracker over ten years as the Magnificent Seven effect strikes again

Laith Khalaf is head of investment analysis at AJ Bell.

Make no mistake, passive funds are eating active managers’ lunch, and the continued good performance of index trackers will do nothing to stop this trend.

Our latest Manager versus Machine report shows that only a third of active equity managers have outperformed a passive alternative in the last 10 years.

To date, in 2024, only 31 percent have achieved this seemingly mediocre achievement.

Whether we look at the short term or zoom out and take a broader perspective, the outlook remains bleak for active managers, and it is the influential global and North American sectors where much of the damage is being done.

The long-term performance of tracking funds in key US and global sectors has been striking.

The idea that a simple American tracker fund could quadruple your money in a decade would have been beyond the wildest dreams of all but the most confident investors.

However, that is precisely what has happened in the last 10 years. In fact, in just the first 11 months of 2024, the average American tracker returned 27.6 percent.

The UK may seem tacky compared to the US, but a 10.5 per cent return on the typical UK tracker in 2024 so far is nothing to sneeze at, and is double what cash rates have been offering more competitive.

Active funds have struggled to keep up because the performance of passive funds has been boosted by the Magnificent Seven tech stocks: Meta, Amazon, Apple, Alphabet, Nvidia, Tesla and Microsoft.

Of course, active managers can invest in these companies, and many do, but few will take on as much exposure as an index tracker.

To match a passive fund, an active U.S. stock manager would now have to hold a third of his portfolio in Magnificent Seven shares, including three individual stock positions above 6 percent each in Apple, Microsoft and Nvidia.

Doing so would guarantee underperformance in that part of the portfolio, after active fees are deducted, and would place a huge burden on the rest of the fund to beat the market, which is, of course, the goal of active management.

When it comes to exposure to The Magnificent Seven, active managers are damned if they do, and damned if they don’t.

The active unrest derived from the good performance of the Magnificent Seven also filters down to the global sector.

Only 17 percent of active funds in the global sector have outperformed a comparable tracking fund over the past decade, the lowest reading since we launched the Manager versus Machine report in 2021.

The U.S. stock market now accounts for 70 percent of the key benchmarks tracked by global tracking funds, but active managers investing globally have been cautious about giving such a high weighting to one market.

The average global equity manager currently holds a hefty 59 percent of their portfolio in U.S. stocks, but that’s still about 10 percent below the typical tracking fund.

When U.S. returns have been much more impressive than the rest of the world, that underweight position really hits active managers where it hurts.

Together, the global and North American sectors account for £317 billion in assets, and the large number of funds they contain means that weak active performance in these areas casts a shadow on the aggregate figures of active equity managers in their set (using sector value data from the Investment Association).

Consequently, it seems quite inevitable that unless and until there is a reversal of the dominant performance of the US stock market and the big tech stocks within it, this report will continue to paint a bleak picture of the fortunes of active managers.

Active fund management is in a critical situation

Active managers are not only suffering in terms of performance relative to their passive peers, but they are also losing the battle for flows.

The last three years have seen an unprecedented decline in active managers in terms of fund flows.

Since the beginning of 2022, £105 billion has been withdrawn from active funds and £48 billion has been invested in passive funds, according to AJ Bell’s analysis of Investment Association data.

The exodus from active funds shows only minimal signs of slowing, and withdrawals in 2024 will be just below last year’s record outflows.

Investors are attracted to passive funds for their simplicity and low cost, not just their performance.

But if we lived in a world where trackers were cheap and cheerful but tended to deliver worse results, active-to-passive traffic wouldn’t be so one-way.

It is possible to point to a reinforcing market cycle at play here. Outperforming passive performance keeps money flowing from active funds to trackers.

Liquidations from active portfolios affect stocks held by active managers, and income flowing into passive funds puts upward pressure on stocks held in tracking portfolios. This, in turn, will tend to improve the relative performance of passive funds and the cycle will begin again.

Despite inflows into passive funds, there has still been a net withdrawal of £56 billion from open-ended funds in total over the past three years (figures do not add up due to rounding).

This reminds us that active funds not only compete with index funds, but they also compete with the following alternatives:

– Investment funds, where wide discounts tell us that demand is also weak;

– ETFs, which are experiencing record global inflows;

– Bitcoin, which is now in the hands of seven million adults in the UK, according to the Financial Conduct Authority;

– Spending, since the cost of living crisis affected the propensity to save and invest;

– Mortgages, which are worth overpaying at higher rates

– Cash, where competitive interest rates have gone from near zero to around 5 percent in the last three years.

In 2021, the FCA identified 8.4 million people who held more than £10,000 in investable assets wholly or mainly in cash and targeted a 20 per cent reduction in that figure as part of its strategy.

But by 2023, this figure had increased to 11.8 million people.

Rachel Reeves can also pat herself on the back for triggering an avalanche of investment fund exits.

In the run-up to the budget, rumors abounded about a capital gains tax raid, and some appeared to have come from the Treasury.

In September and October, retail investors withdrew more than £9bn from investment funds as they struggled to collect profits ahead of a potential capital gains tax raid, according to Investment Association data.

It’s reasonable to assume that the rise in passive fund sales must end somewhere, but we may still be a long way from that point.

Currently, trackers account for 24 percent of funds managed by Investment Association members.

But in the United States, the asset value of passive funds surpassed active funds for the first time last year, according to Morningstar.

In other words, more than 50 percent of the fund’s assets were invested passively.

The index investing megatrend started in the US, so it sets out a significant roadmap for where the UK investment industry may end up.

In other words, don’t bet the house on a revival of active management in the short term.