This does not come as a surprise to DeMiguel. “We know that index funds have consistently outperformed actively managed funds for more than 10 years. And when you factor in the cost of managing them – most charge investors around 1% in annual fees compared to 0.5% or less for passive funds—it’s hardly surprising that most people will walk away.”
So is there any benefit to investing in active funds?
There is some indication that a small proportion actually do outperform the market each year, yielding outsize returns for investors intrepid enough to have entrusted their cash. While around 90% of active equity funds underperform their index, a minority are still able to beat the trackers. And they do so on the basis of their ability to spot under or over-priced stock in a given index – an expertise that can also help drive efficiency in the market by figuring out the true value of assets. Nonetheless, for investors, the issue is identifying these outliers in advance, and this is notoriously difficult because past performance is not a reliable indication of future market returns.
“Knowing that some of these funds do beat the market, you might be tempted to look at which of them have performed well in the last five or 10 years,” says Victor. “The problem is that there’s no persistence in performance. The funds that did brilliantly over the last five or 10 years won’t necessarily be the ones beating the market in the next five or 10 years. The past alone isn’t a reliable marker of future performance.”
So what other markers might there be?
Predicting performance
To pinpoint which active funds are most likely to outplay the market, Victor and his colleagues have built an algorithm that can factor in a whole slew of characteristics besides past performance. Their algorithm integrates 17 different features from things like how many assets a fund has under management to beta – its sensitivity to market fluctuations – onto things like the tenure of its mangers, their length of time managing the fund, turnover, expense ratio, what the fund charges for its services and more. And that’s not all. The algorithm can also analyse synergies or complex relationships between these variables and process the different ways that they interact to make accurate predictions about future outcomes.