Vanguard research finds costs to be major factor in long-term underperformance of active funds

Nov 15th, 2012 | By | Category: ETF and Index News

A comprehensive analysis of fund returns in the UK by Vanguard has revealed that costs are the central contributing factor underlying the underperformance of active funds versus their benchmarks over the long-term.

Vanguard research finds costs to be major factor in long-term underperformance of active funds

Peter Westaway, Chief Economist at Vanguard.

According to Vanguard’s Case for Indexing research, only 17% of active equity funds and 4% of active fixed income funds that were in existence in 1997 outperformed their prospectus benchmark over the subsequent 15 years. The report revealed similar levels of underperformance over five- and ten-year periods.

Vanguard compared Morningstar performance data on equity funds (UK, European, Eurozone, US, Global and Emerging Markets) and fixed income funds (UK diversified bonds, UK Government bonds, Global, USD and euro diversified) to the performance of the benchmark quoted in the fund’s prospectus. Vanguard’s research found that survivor bias – the tendency for funds with poor results to be closed or merged, leading to false conclusions about overall active management performance – helped to mask the true level of underperformance.

Tom Rampulla, Managing Director of Vanguard, said: “Many investors will be disappointed by the level of underperformance across a range of active equity and bond funds. Our research illustrates just how rare it was for active funds to consistently outperform over the long term. The high costs that often go hand in hand with active fund management are a considerable drag on performance.”

The report also highlights the difficulties in selecting the best-performing active managers based on past performance. An actively-managed UK equity fund that was ranked in the top quintile in the five years ending December 2006 was more likely to fall into the bottom quintile (23.4%) than remain in the top quintile (15.6%) five years later. Over the same time period, 60% of top-quintile funds in 2006 fell into the bottom 40% of all funds, or closed completely.

The report’s co-author Peter Westaway, Chief Economist (Europe) at Vanguard, pictured, said: “These figures show the challenge facing even the most skilled professional investor looking to pick the right active manager.  The research shows that there was no strong link between past and future performance. Historical data was a very poor indicator and teaches us little.”

He added: “The data suggests that most strategies for picking outperforming active funds are likely to fail. Over each time period that we examined, only a small number of active funds outperformed. Index-tracking funds have a cost-driven tail-wind relative to the vast majority of actively managed funds, and have delivered better returns than all but a few active vehicles.”

The report helps build on the already strong case for passive index-tracking products such as exchange-traded funds (ETFs).

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