All clients of Evolve will be well aware that our investment strategy is based on using low cost index tracking funds.  We are passionate about keeping the cost of investment as low as possible and very much hope the entrance of Vanguard into the UK market will force other fund managers to reduce their charges.

One criticism we often face from supporters of “actively managed funds” is that index funds simply don’t work in falling markets.  Their view is that active fund managers can use their investment knowledge and skill to switch their holding in equity positions to cash and therefore outperform the market.  Evidence has never supported this claim, but recent research from Standard & Poor’s Index Services shows that the opposite is true.

In a report dated 20/04/2009, S&P concluded that between 2004 and 2008 the S&P 500 index outperformed 71.09% of actively managed large cap funds.  In addition to this, the S&P Mid Cap 400 index outperformed 75.9% of mid-cap funds and the S&P Small Cap 600 Index outperformed a staggering 85.5% of small cap funds.  This last statistic is particularly interesting, as smaller company managers often claim that since small cap stocks are not so well researched it is easier to exploit market inefficiencies.

Srikant Dash, the global head of research and design at Standard & Poor’s stated that “The belief that bear markets strongly favour active management is a myth”.

S&P also noted that the bear market of 1999 to 2003 showed similar outcomes.  What is interesting is that S&P stated that the result they found for the US markets were repeated internationally and with fixed income funds too.

So why do active managers underperform so consistently?  At Evolve we acknowledge that fund managers as a whole are a bright bunch.  Indeed, research from Randy Cohen of the Harvard Business School and Christopher Polk and Bernhard Silli of the London School of Economics shows that the average fund manager can spot good stocks.

They have estimated that since 1990 the average US fund manager’s best idea (their most overweight position) has beaten the market by 4.8% per annum.  Yet the average fund does not out perform the market.  So why is this?  The reason is that most funds will own an average of around 100 companies which means that any outperformance in their best stock picks is soon diluted.

This begs the question why the fund manager holds so many stocks.  The charitable reason is that they need to for liquidity reasons.  Often a manager will not be able to buy enough of a company they want to because they would either hold too much of the company or may not be able to buy the stock at what they deem to be a fair price.

The less charitable view is that they hold so many stocks in order to track the market.  Most active funds, in our opinion, are quasi trackers that broadly mirror the market as a whole.  The manager may take a few modest stock or sector bets, but cannot afford to sway too far in case he or she picks the wrong ones!  The result is an expensive fund that will have a few modest bets, none of which are likely to be enough to outweigh the costs.

We are always looking for strong evidence as to why we should not recommend index funds, but nothing we have seen to date has made us alter our view.