Most fund managers don’t know how to diversify, leaving investors better off tracking the market through passives, according to Argonaut Absolute Return manager Barry Norris.
He said the majority of actively managed equity funds are so highly correlated that investors have no benefit to holding multiple ones together in their portfolio.
“The problem with our industry is that so few people understand how to diversify and that you can only do that properly with assets that aren't correlated to each other,” Norris explained.
“An example you often see is when people have a portfolio of say 10 funds. Those 10 funds might all have good Sharpe ratios individually, but if they all deliver at the same time as each other, you’ve got no benefit of diversification.”
Indeed, the close similarities in styles and allocations across active funds means that many of them tend to perform alike at the same times.
Norris used 2022 as an example – last year was characterised by challenging market conditions such as high inflation and rising interest rates, meaning 82.6% of all Investment Association (IA) funds delivered a negative return across those 12 months.
Because most funds behaved similarly, it was difficult for investors to find one of the few funds that was uncorrelated enough to deliver differing returns.
“There are lots of flat track bullies in the investment management industry whose funds do well when the market does well but there are very few that perform well when the going gets tough,” Norris said.
“People just don't want to stand out. Most people in the fund management industry are average because trying to offer a different return makes you look more volatile and it takes more career risk.
“Those people think there’s safety in being part of the crowd, but too often people confuse volatility with correlation.”
This was backed up by VT Tyndall Real Income manager Simon Murphy, who also noticed a concerningly high level of correlation across active equity funds.
Like Norris, he said too many managers seek safety in holding the generic names that are popular amongst their peers rather than taking risks in other more neglected parts of the market.
“I don't think active fund managers take enough risk in their portfolios to deliver the return that clients of active funds expect, especially after fees,” Murphy explained.
“It’s because people really don’t like to stand out from the crowd too much and they're worried about short-term volatility, performance and career risk if they get things wrong. There’s this herd mentality.”
This is something Murphy noticed broadly across all Investment Association (IA) sectors, but it is commonplace in the UK equity market where he primarily invests.
Many funds the IA UK Equity Income sector are inundated with the same large-cap stocks, leading Murphy to avoid the upper half of the FTSE 100 altogether. In doing so, he hoped not to fall into the trap of sharing the same high correlation most of his peers have.
“You’ve got a large concentration towards some very big funds, and those funds tend to be highly exposed to the same very large stocks,” he added.
“No matter how hard you try, you tend to look and behave quite similarly and that’s constantly making me want to do something meaningfully different.”
Not only did actively managed funds fail to make a positive return last year, but they were also beaten three to one by passive index trackers.
Passive funds outperformed in 29 IA sectors compared to just nine where active managers won, leading Norris to question just how effective active funds are, especially considering they charge much higher fees than their passive counterparts.
“I think the problem with the fund management industry is that 99% of equity funds go up and down at the same time,” he said. “Active managers that try to compete with passive managers tend to lose.
“My view is that, if you want to buy market exposure, you can buy that cheaply through a passive because no active manager is going to be able to provide that cheaper.
“To my mind, there's no future in active management selling beta products. That’s why we're trying to provide a return profile that delivers at different times to the market and all other equity funds.”
With passive funds offering better performance and diversification at a lower fee, investors may want to question whether the higher charges they’re paying on active funds are worth it, according to Norris.
He concluded: “You’ve got to ask yourself: are you actually paying a performance fee for beta you could just buy cheaply through a passive?
“They [active funds] don't actually provide useful diversification to people, because when they have their bad bumps, so does everybody else at the same time, which makes it seem as though it’s all right.”