Can fund managers recover from a bad patch or is your money better off in a passive fund?

Managed funds have seen a slowdown of late and many have fallen behind passive funds in terms of performance.

With passive funds proving to be a much cheaper option for investors, it is no surprise that an increasing number are choosing to move their investments to passive trackers.

In 2024, the total assets of U.S. passive funds surpassed those of active funds for the first time, according to Morningstar.

In the second quarter of the year, passive funds continued to record net inflows into the UK, while active funds recorded net outflows.

Passive funds now represent 30 per cent of the UK fund space, with assets of more than £340 billion.

However, with some active funds suffering, AJ Bell’s Dan Coatsworth says there could also be an opportunity for investors to buy ahead of a rebound in their fortunes.

Coatsworth, investment analyst at investment platform DIY, said: ‘Investing in funds can be a journey of ups and downs.

When a fund experiences a period of underperformance, it can lead investors to question whether it offers a buying opportunity in the hope of a rebound or an exit signal.’

How can you detect a buying opportunity?

Three is the magic number. On average, investors hold the funds for only three years. But when it comes to judging the performance of an active manager it is not enough to actually evaluate the quality of the fund.

In 1997, the average holding period was eight years.

Coatsworth said: ‘Previous research has shown that fund managers who were fired after three years of poor performance often delivered positive returns after that point, frequently outperforming those of their replacements. This suggests that a temporary slowdown may not always signal the end of a fund’s streak of good performance.

“While a three-year period has become an unofficial benchmark for evaluating fund performance, it is crucial to recognize that fund managers are unlikely to consistently outperform an index or peer group.”

Instead, the key, Coatsworth says, is to focus on the philosophy and process behind a fund’s investments, especially their consistency.

“If a fund manager deviates from his or her stated approach, it may indicate potential future underperformance due to ‘style drift,'” he said.

The fund’s performance could also be affected by changes in the number of shares held or transactions made, or by the replacement of a fund manager.

Coatsworth said: “While a new perspective can sometimes improve performance, the departure of an experienced manager can mean a substantial change in strategy.”

Temple Bar Investment Trust, for example, saw its performance decline between 2018 and 2021, before a strong rebound in recent years.

What active funds are hoping to recover?

Slower growth (current expenses: 1.54 percent)

An example of the thesis that three years is too short to judge a fund, according to Coatsworth, is Slater Growth.

Slater Growth, despite having underperformed over the past three years, having fallen 27 per cent compared to the IA UK All Companies Index’s 5 per cent rise, has returned 516 per cent since 2005, more than double the 228 per cent rise in the IA UK All Companies Index over the same period.

Coatsworth said: ‘The manager’s pedigree suggests the fund has good recovery potential. Slater applies a proven investment process which begins with an assessment of the UK universe across several criteria.’

He said: “Slater attributes the recent underperformance to a large downgrade in the small and mid-cap parts of the UK market, plus a rise in interest rates, accentuated by fund outflows.”

Montanaro United Kingdom Smaller Companies (ongoing expenses: 1.3 percent)

Coatsworth also says the embattled Montanaro is a buying opportunity as the fund benefits from the overall outperformance of small caps versus larger caps over the long term.

Coatsworth said: “The dearth of publicly available research means there is plenty of opportunity for Montanaro’s team to find undiscovered gems.”

“The team looks for simple businesses in different niches, which makes them less vulnerable to the vagaries of the economic cycle, and they must be profitable.”

Montanaro also pays a quarterly dividend of one percent of its net asset value, yielding 4 percent each year.

“The fund returned to normal in the first half of 2024, outperforming the index when it became clear that rates were going to fall, but the slow pace of cuts has slowed it in the third quarter despite the positive results of the portfolio companies,” Coatsworth said.

RIT Capital Partners (Ongoing costs: 0.77 percent)

Similarly, RIT Capital has struggled in recent years, losing 27 percent.

However, Coatsworth says that despite this crisis, the fund could now regain its strength.

“More recently, manager Maggie Fanari has been articulating her plan to revive the trust’s fortunes to investors who have seen a rebound in portfolio performance, as buybacks continue apace and falling interest rates should offer a tailwind,” he said.

“As at 30 September 2024, the net asset value was £26.19 per share, up 1.5 per cent on the previous month, meaning the fund had generated a positive net asset value total return. 8.8 percent so far this year.”