Passive funds beat active funds, according to the ESMA

On September 10th of 2019, the ESMA (European Securities and Markets Authority) published a report that compares the performance of active and passive funds. It’s called “Net performance of active and passive equity UCITS” and you can download a copy here. For this article, I picked out its most interesting conclusions.

Importance of the report

I think this report is important to the European passive investor because it’s the first time that such an analysis has been done by an independent, European institution. We are passive investors because we have seen sufficient evidence that passive investing beats active investing. However, the evidence has always come from research focused on US markets, or done by providers of passive funds that have an incentive to send out this message (e.g. Vanguard).

The ESMA is the EU-wide financial markets watchdog and one of its core missions is to protect the European retail investor. For this reason, I put a lot of trust in the research presented in the report.

Active funds still dominate investing but it’s changing

The chart below compares the assets in active funds and passive funds. Active funds still hold over 75% of all assets while passive funds and ETFs account for the remaining 25%. However, passive funds are gradually taking assets away from active funds: in 2014, only 18% of assets was passively invested.

Passive funds outperform active funds

Over the long term, the gross performance of active and passive funds are similar. However, when taking into account the ongoing costs of the funds, passive funds outperform their active counterparts. Ongoing costs for passive funds lie between 0% and 1% whereas active funds charge between 1% and 3%. And that makes all the difference in the return that the investor sees.

Actively managed funds are underperforming relative to their prospectus benchmarks

Most active funds try to beat a benchmark that they set when the fund is created, for instance the MSCI World index. It turns out that most active funds don’t manage to beat their benchmark. If you’re invested in a fund that tries to beat the MSCI World index but never succeeds, take your money out and put it in a MSCI World fund instead!

The best active funds are not consistently the best

Our analysis shows that the composition of the top 25% of actively managed equity UCITS changes materially over time. (…) As such, there is only limited opportunity for investors to pick consistently outperforming actively managed equity UCITS.

This is an interesting observation. The top 25% active funds of 2013-2018 weren’t the same as those of 2008-2013. Furthermore, the top active funds over a 7-year period underperformed passive funds in net returns.

This shows that for long-term investing, sticking to one active fund is a worse strategy than passive investing. Instead, if you want to outperform passive investing, you need to switch active funds every so few years. But then you find yourself “fund-picking”, with all the same problems as stock-picking.

Larger active funds have a better performance than smaller funds

On average, larger funds have higher performance both in gross and net terms, possibly related to lower costs as a consequence of economies of scale.

When you do choose an active fund (not that you should), opt for a larger fund. They tend to have a higher performance and be cheaper than smaller active funds.

Higher TER does not lead to higher performance

The figure below shows that a more expensive fund will not necessarily have a better performance. This holds for both active and passive funds. There is no correlation between the TER of a fund and its return. If there was a positive correlation, we should have seen a trend in the chart going from the bottom left to the top right.