Not what was forecast: UK index funds lagging active managers

Many UK active funds are now outperforming passive funds. But prejudices rarely disappear when hit with the facts. It is human nature to disregard data that contradicts our misplaced beliefs. This may be why little attention has been paid to the remarkable results of many active UK fund managers – in the face of much criticism from index funds and other critics. The underlying factors driving this surprising pattern confound much that is predicted by theories of market efficiency.

Why is this happening? And, more importantly, will the critics take note? Of more than 200 funds with long records in the IA UK All Companies Sector, the median fund is well ahead of the FTSE All-Share Index. This applies over the 1, 2, 3, 4 and 5 year records to date.

Most of the funds are beating the index, and consequently leaving passive funds behind, too. And, this does not appear to be driven by greater risk, but by identifying underlying stockmarket behaviour and factoring that into stock selection. The main driver of this result for stockpicking is the long-term outperformance of UK medium-sized companies. A number of active institutional investors focus on this mid cap area, keeping these trends on their side. The FTSE 100 Index, representing the UK’s biggest companies, has gained 33% in capital terms in the last 5 years.

By comparison, the index of medium sized companies, covering the next 250 listed businesses below the 100, is up over 80% in the same period. This index began almost 30 years ago, and has risen almost 12-fold in that time. In comparison, the FTSE 100 Index is up just 6-fold in 3 decades, lagging mid cap in most periods. Quite a gap.

Investors will note that individual shares can do a lot better or worse than the average of their peer group. Understandably, some investors have recognised this persistent pattern by focusing their portfolios on the performing area of the market. The largest funds may be constrained in terms of liquidity, but many find mid cap offers the right balance of risk and reward.

There may even be reasons for the longer term performance pattern, arising from distinctive characteristics of British medium-sized companies. The FTSE 250 has fewer major global businesses and emphasises some domestic British sectors that are less well represented in the FTSE 100. These sectors include engineering and industrials, utilities, business services and many consumer sectors.

In contrast, the FTSE 100 includes some businesses, such as the international mining groups, that bear little relation to the UK economy. Active managers can apply judgement on whether they need mining in their portfolios; the point of index funds is not thinking too deeply. Thinking and risk management cost money.

Multi-nationals at the top of the FTSE 100 are often seen as “quality” companies, with a blue-chip aura. But this can be false comfort. There are no guarantees that spending more on management or boards, with big bonuses, actually drives better performance. Investors only have to think of BP, Tesco and most banks to see that multi-nationals can be accident prone.

This goes some way to explaining the big long-term performance gap between large and medium. Now may not even be a good phase in the economic cycle for the broad international exposure of multi-nationals. Fears that the US Federal Reserve will raise interest rates have triggered weakness in emerging markets. It is easy to see that big global businesses might be more exposed to the fierce competitive and deflationary pressures that arise with internationally-traded products and services.

While many FTSE 250 businesses have global interests, these are more typically in niches that afford some growth and price protection. In a world where many sectors are being disrupted, there may be no safety in scale. The statistics challenge a number of core beliefs; that big blue-chips are better, fund costs matter most and that markets are efficient. The view that fund selection is mainly about cost is taking a knock – in what is a core area of UK wealth management.

This is unlikely to be a death knell for UK index funds, as large funds need significant exposure to the biggest stocks. However, the prevailing wisdom that active management in UK shares is a zero sum game, is getting a reality check. UK mid-cap may only be a pocket of inefficiency, but a remarkably large and persistent one.

Capital is at risk with investment.

A version of this article was published in the Behavioural Finance series of Citywire Wealth on July 23, 2015. At the time of writing the author, his employer and its clients did not have any positions in the companies mentioned. .

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