Active vs passive: how the debate stacks up in Europe ex UK equities

The debate as to whether active managers can add value for their clients has intensified in recent years. The financial media has delivered an abundance of headline-grabbing statistics that have led many investors to question whether active managers can justify their fees:

• 99% of actively managed US equity funds underperform – Financial Times, 24 October 2016
• Fund managers rarely outperform the market for long – The Economist, 24 June 2017

These eye-catching articles suggest that active management is comprehensively losing the battle, and US flow data suggests many investors have reached the same conclusion. While Europe has not seen passive fund inflows to the same extent as the US, such inflows have overtaken those into active funds since 2012, as the chart below illustrates.

However, despite the high correlation we see between equity market returns across the globe, there is a danger that the conclusions drawn from the performance of active managers in large cap US equities are allowed to diffuse across the entire industry without similar support from the data.

It is also worth noting that there is a whole host of methodologies used when making arguments to criticise or defend active management. Do you benchmark active funds against market indices or passive trackers? Do you include passive funds in the peer group? How do you define the peer group? What actually constitutes a "passive return"?

Schroders considered these issues in a broader paper in 2017: The case for active asset management. We have now run an analysis for Europe ex UK equity funds.

When looking at Europe ex UK equities, we assess our performance against a set peer group based on definitions made by the Investment Association (“IA”), the trade body that represents UK investment managers. We therefore concluded that it would be helpful to create our own active versus passive analysis based on the same parameters.

Methodology

Using the IA defined primary share class, net of fees, for the IA Europe ex UK peer group excluding index trackers, we have equally weighted all funds and calculated five-year performance with a rolling three-month window dating back over the last 20 years. The data includes closed funds to account for survivorship bias.

We believe that a passive fund, as opposed to an index, should be used to represent passive performance, as this represents the performance that a client could actually receive from a passive investment, taking fees and other costs into account.

We chose the L&G European Index Trust I Acc to represent passive performance. It has the longest track record of all the passive funds in the sector, with a rolling five-year track record dating back to 1995. Furthermore, it has a 12 basis point fee, it is the second largest tracker in the sector (>£3 billion) and has demonstrated an ability to track the index accurately. Importantly, it has consistently outperformed the average Europe ex UK tracker return.

Performance

The quartile performance chart below reveals how the IA Europe ex UK peer group has performed versus the return of the L&G tracker for over two decades.

Aside from a few years between 2007 and 2011 where the tracker’s five-year returns hovered around the 45^th percentile - i.e. in the 2^nd quartile - most active investors in the peer group outperformed the passive return. 

The chart below sheds more light on the success of active management in the sector. If the tracker is between the 50^th and 100^th percentiles (shaded in pink in the chart), as it has been for the majority of the last two decades, then passive has underperformed the average active fund.

The few years where passive investing does achieve slight outperformance were followed by a period of significant underperformance, as the tracker moved from the 41^st percentile to the 80^th between 2011 and 2015, shown below.

Clearly then active managers have a strong case to make in Europe ex UK equities. While the evidence seems to be stacked against active managers in the US, the same cannot be said for this market, as the data clearly demonstrates across the last two decades.

Apart from around four years in the mid-noughties, the majority of active funds have delivered better returns net of fees than the leading passive fund. Investors need to keep an open mind on using active management in European equities.