A 10-year study by David Blake, Tristan Caulfield, Christos Ioannidis and Ian Tonks at clearing and settlement Business School discovered 99 per cent of equity funds did not beat their benchmark through stock selection or market timing, after fees were subtracted.

Examining the monthly returns of 516 UK open-ended equity funds between 1998 and 2008, the study revealed:

• an average annual post-fee alpha return of negative 1.44 per cent
• yet fund managers extract the full rent from their skills in the fees that they charge

Pensions Institute director Blake says: “This suggests that a typical investor would be almost 1.44 per cent a year better off by switching to a low-cost passive UK equity tracker.” The “star manager” culture helped active management retain its lustre, Blake says, however just 1 per cent of managers are able to return more than trading and operating costs.

Funds should be split when reach critical size

In a second paper, the Cass Business School authors argue funds should split once they hit “a critical size” to protect investor returns. Using the same data as the first study, the authors discovered that:

• annual alpha generation dropped 9 basis points for every 1 per cent increase in assets under management.
• large funds under perform smaller ones because the growing footprint in the same stocks pushes up prices and lowers yields, the report concludes.

Blake said the findings suggest funds should consider splitting when they reach a critical size. “The most likely explanation for the negative relationship between fund size and performance is the negative market impact of large funds attempting to trade in size,” he explains.

Methodology

The studies were conducted using bootstrapping, a statistical technique allowing the researchers to construct a distribution of returns that a fund manager could achieve by luck alone.

IMA reaction

An IMA spokesman says it is up to advisers and investors to choose which funds they buy into. “Our focus is on ensuring transparency, simplicity and consistency of charges and costs, regardless of a fund’s approach to investment,” he adds.