Only a third of fund managers beat a cheap tracker in the past decade 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 continued strong performance from index trackers will do nothing to buck this trend.

Our latest Manager vs. Machine report shows that only a third of active equity managers have outperformed a passive alternative over the past ten years.

So far in 2024, only 31 percent have managed this seemingly mediocre performance.

Whether you look at the short term or zoom out and take a broader perspective, the picture 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 tracker funds across key US and global sectors has been nothing short of astonishing.

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

Yet that is exactly what has happened over the past decade. In the first eleven months of 2024 alone, the average American tracker returned 27.6 percent.

The UK may seem pedestrian compared to the US, but a 10.5 percent return over the typical UK tracker in 2024 is nothing to sniff at so far, and is double what the most competitive cash rates offered.

Active funds have struggled to keep up as passive fund performance has been driven by the Magnificent Seven technology stocks: Meta, Amazon, Apple, Alphabet, Nvidia, Tesla and Microsoft.

Active managers can of course invest in these companies, and many do, but few will get as much exposure as an index tracker.

To match a passive fund, an active US stock manager would now have to hold a third of his portfolio in Magnificent Seven stocks, including three individual stock positions of more than 6 percent in Apple, Microsoft and Nvidia.

Doing so will guarantee underperformance of that part of the portfolio, after active fees are deducted, and heavily tax the rest of the fund to beat the market, which is of course the goal of active management.

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

The active malaise resulting from the strong performance of the Magnificent Seven is also trickling down to the global sector.

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

The US stock market now makes up 70 percent of the major benchmark indices, followed by global tracker funds, but active managers investing globally have been reluctant to assign such a high weighting to one market.

The average global equity manager currently owns a significant 59 percent of their portfolio in US equities, but that’s still about 10 percent less than the average tracker fund.

While returns from the US are so much more impressive than those from 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 over the overall figures for active equity managers as a whole (based on sector value data of the Investment Association).

It seems almost inevitable, then, that unless and until there is a reversal in 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 fate of active managers.

Active fund management is in a critical state

Active managers not only suffer in terms of performance compared to their passive colleagues, they also lose the battle for capital flows.

Over the past three years we have witnessed an unprecedented rout for active managers in terms of money flows.

Since the start of 2022, £105 billion has been withdrawn from active funds and £48 billion invested into passive funds, based on AJ Bell analysis of Investment Association data.

The exodus from active funds shows only the barest signs of abating, with withdrawals in 2024 on track to fall just short of last year’s record outflows.

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

But if we lived in a world where trackers were cheap and cheerful, but tended to produce worse results, the movement from active to passive wouldn’t be entirely one-way.

It is possible to point to a strengthening market cycle at play here. Superior passive performance leads to money flowing from active funds into trackers.

Liquidations of active portfolios dent the stocks held by active managers and the returns flowing into passive funds put upward pressure on the stocks in tracker portfolios. This will in turn improve the relative performance of passive funds, and the cycle begins again.

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

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

– Investment trusts, where deep discounts tell us demand is also weak;

– ETFs, which are seeing record flows globally;

– Bitcoin, now owned by seven million adults in Britain, according to the Financial Conduct Authority;

– Expenditure, as the cost of living crisis affected the propensity to save and invest;

– Mortgages, which are worth overpaying at higher rates

– Cash, with competitive interest rates rising from near zero to around 5 percent over the past three years.

In 2021, the FCA identified 8.4 million people who had more than £10,000 in investable assets, all or mostly in cash, and aimed to reduce that number by 20 per cent as part of its strategy.

But by 2023, this number had risen to 11.8 million people.

Rachel Reeves can also take a bow for triggering a wave of mutual fund outflows.

In the run-up to the Budget, there were plenty of rumors of a capital gains tax raid, and some appeared to come from within the Treasury.

More than £9 billion was withdrawn from investment funds by retail investors in September and October as they scrambled to cash in on gains ahead of a potential capital gains tax, according to data from the Investment Association.

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

Trackers currently make up 24 percent of funds managed by Investment Association members.

But in the US, the value of assets in passive funds surpassed active funds for the first time last year, according to Morningstar.

In other words: more than 50 percent of the fund assets were invested passively.

The index investing megatrend started in the US, so it provides a meaningful roadmap for where the UK investment industry could ultimately end up.

In other words, don’t count on a revival of active management happening anytime soon.