The point of most actively managed investment funds is to beat the market, but in order to beat the market they must in some way be different from the market.

Generally speaking, the more different an investment fund is from the market the more chance it has of outperforming.  On the other hand, the more similar it is the less chance it has of outperforming.

If that’s the case, why do so many actively managed investment funds mimic the market so closely?  Is there an epidemic of closet index trackers in the UK?

This problem was highlighted in a recent report by SCM Private (which is available on their website).  The study looked at investment funds which benchmark themselves against the FTSE All-Share.

The key findings were that:

  • A typical fund will be about 40% identical to the index
  • Almost half of all funds investigated were “closet indexers” (defined as being less than 60% different from the index)
  • Funds that were more than 50% identical to the index had underperformed by 1.1% per year over the past 5 years, while funds that were more than 50% different had outperformed by 1.6% per year

Why active fund managers stick close to the market

Although it’s generally true that being different from the market creates more opportunity to outperform the market, it also creates more opportunity to underperform the market.  Most retail investors buy funds which have recently beaten the market, and sell funds which have recently fallen behind the market.

The result is that many fund managers are terrified of underperforming in the short-term, because they’ll lose investors.  If they lose investors they will lose assets under management, which will reduce their management fees, which will possibly cost them their jobs.

That’s why many investment managers hold the same investments as the market.  If they invest in a way that’s very similar to the market then they can’t underperform by much.  If they don’t underperform then retail investors are likely to stick with them even if they don’t outperform.  That’s because funds are like bank accounts; most people find it easier to stay put than to switch.

Eventually even a closet indexer will get lucky and outperform the market for a short while.  When they outperform they’ll pick up new investors and new assets under management.  If they’re very lucky they may win an award for their…

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