Going nowhere?

Now, with a rangebound, sideways market, many fund strategists are still incredulous. Surely in this sort of investment environment only highly skilled active managers are able to make money?

But this scepticism is at odds with the conviction of the UK
institutional investment market, where a third of pension fund money is invested in passive funds; and with retail investors in the US, where passive investment houses dominate the massive Schwab wrap platform. Index funds are also popular in Australia, which shares the US’s fee-based approach to financial advice.

So should fund strategists reconsider the role of index funds, and why is there this culture clash between the retail and institutional sectors?

The institutions argue that studies show that active managers tend to underperform over the long term. The average retail active fund has to work harder than the average index fund because of the effect of charges. Active equity funds cost perhaps 1.5-1.75% annually, while index trackers deduct as little as 0.3% (see table on page 21).

Passive funds also have lower transaction costs, as fund turnover is much lower than with active funds.

Furthermore, it is estimated that a large proportion – some say as many as 70% – of UK All Companies funds are quasi-trackers that shadow the benchmark while charging higher fees. These will
underperform because of their fees, and do not even have the
advantages of genuinely active investment.

IThere are times, such as the last 18 months, when active managers have fared better. Mid and small-caps have outperformed the UK market as a whole, and active managers have played this theme effectively.

But consistently outperforming fund managers are a rarity over the longerterm.

Statistical analyst WM says that out of the 44 UK All Companies funds with a full 20 years of performance history, just eight outperformed the index. Identifying consistently outperforming fund managers is easy with hindsight, but to predict is almost impossible.

What is more, according to WM’s head of research Alistair MacDougall, a manager needs a 20-year track record for us to be able to
understand statistically whether his outperformance is a matter of skill – and therefore sustainable – or simply luck. There are few of that sort around, with Anthony Bolton, manager of Fidelity UK Special Situations, being the most obvious example.

MacDougall suspects a lot of intermediaries make recommendations on the back of short-term performance models rather than skill. “We all know stories of investors put into the latest hot funds. I question if that’s the wise thing to do,” he says.

Jason Butler, managing director of Bloomsbury Financial Planning, is an evangelist for index trackers: “I was brought up on active management. I’ve thrown off the shackles. We never have to turn round to clients and say sorry.” He adds: “You have to eat a lot of humble pie, and leave your ego at the door.”

Butler says active funds are too expensive, and there is no reliable way to pick outperforming managers in advance. He describes people who think they can pick managers who will be able to outperform the market as “idiots”, and adds that there are two types of adviser: one who does not know the right managers to choose, and the other who does not know he does not know.

Butler accuses fund houses of peddling “financial pornography”, seeking to stimulate investors into taking action that ultimately will not do them any good, and says people normally get both timing and selection decisions wrong. He instead assesses client attitude to risk and offers an appropriate asset allocation, based on passive funds. He says 90% of performance is a result of asset allocation rather than picking the right stocks, and the company’s asset allocation approach maintains more client wealth over bear market conditions.

Butler does not aim to beat the market and questions whether clients actually need to outperform. His minimum time period for equity investing is 10 years. In one popular portfolio model, 50% is put into equities and 50% into bonds. The former is split equally between UK and overseas equities; of this 25% UK equity allocation, 17.5% goes into a FTSE All-Share tracker, and 3.75% apiece is invested in a specialist value share tracker and a specialist smaller companies tracker. The value style and smaller companies components are designed to boost returns.

These two specialist funds are “pure” funds provided by Dimensional Fund Advisors, an American passive investment house recently
established in the UK. Bloomsbury also uses Dimensional’s emerging market tracker. The pure funds strip out investment trusts, initial public offerings and utilities, as these are subject to price caps and can impede performance.

In common with Butler, pension funds invest over a longer period.

According to Gary Dowsett, senior investment consultant at Watson Wyatt, asset allocation is key to enabling pension funds eventually to match liabilities.

Mercer Investment Consulting senior consultant Stephen Woodcock – who, like Dowsett, advises pension funds on investment strategies – agrees that asset allocation is crucial. If investors believe the markets will move sideways for the next 10 years, the argument is not an active/passive one, but a debate about asset class – perhaps favouring a market-neutral strategy using hedge funds. Investors buy equities because they expect to be rewarded with higher returns for taking the risk. Woodcock says: “If you take a risk, but see no real prospect of reward for doing so, this is a curious investment decision.”

Popular among the institutions, but to a lesser extent with
intermediaries, is the idea of core/satellite investing. Index funds constitute the core of the portfolio, with as many as six
higher-risk, actively managed “satellite” funds that may deliver outperformance.

Many pension funds are keen on this approach, as it is a
cost-effective way of exposing the portfolio to a limited amount of relative risk. The traditional active approach, aiming for small outperformance on the whole fund, is more expensive. Pension funds might look for a 60/40 active/passive split, or perhaps 80/20.

Chamberlain de Broe technical director Mark Bolland likes the core/satellite theme, with index trackers as the long-term core holding. He likens it to the “old days”, when blue-chips such as Shell, Glaxo, Marks & Spencer and Hanson made up the core of stockbroker portfolios. The satellite elements were funds or shares moved in and out of more actively. Bolland says the passive element could be 70-80% of a client’s equity portfolio.

But Chase de Vere investment manager Anna Bowes says that although index funds could be considered core investments, they should make up a far smaller proportion of a portfolio. She emphasises that trackers are not inherently low risk. Bowes herself prefers active funds, and thinks equity income, cautious managed or distribution funds make for good core holdings: “My money is invested with Neil Woodford [manager of Invesco Perpetual Income and High Income funds], and has been long term. It’s a good defensive stock, and where I’d want to be if the market fell like a stone.” Bloomsbury’s Butler says he has not seen any convincing research to show that core/satellite investing has value, and cannot see any justification for using actively managed funds at all.

Fund strategists use index funds for a variety of purposes. John Scott & Partners purchases FTSE 100 trackers to give clients large-cap exposure. Patrick Connolly, research and investment manager, says the large-cap market is efficient, and historically it has been difficult for UK large-cap funds to beat the index.

It is hard to beat the S&P 500 in the US too, but the company has still found ways to include actively run US large-cap funds. Connolly says good UK mid and small-cap managers should be able to outperform the index, and the same is true for Europe and Japan.

BestInvest investment adviser Justin Modray says index funds can make sense for the UK and US markets. But in regions such as the Far East and emerging markets, active funds tend to outperform the index. He says he might recommend trackers for individuals who want some stockmarket exposure, but cannot stomach too much risk.

Juliet Schooling, head of research at Chelsea Financial Services, says people often use index trackers as a first step into the stockmarket when they do not feel they understand enough to go for anything more actively managed. Also, passive funds can be a useful vehicle if investors want to put money into the stockmarket and not think about it for 10 or15 years – for example, for a pension or investing for grandchildren.

Schooling prefers UK All-Share trackers to FTSE 100 products, as the latter are dominated by a small number of shares and sectors.

Hargreaves Lansdown head of research Mark Dampier says that as with all investment styles, index trackers will have their day. Sometimes passive funds perform brilliantly and investors should own them. If the market explodes, the movement is generally led by blue-chips, which dominate index-tracking funds. FTSE 100 stocks account for 85% of the FTSE All-Share.

Mick Gilligan, associate director of fund research at Killik & Co, says that as there were a couple of strong bounces led by the FTSE 100 in the last quarter, holding index trackers in that period would have proved a better bet than active funds.

Dampier says in the 20-year bull market trackers worked well – especially from 1996 to 1999, when blue-chip stocks led the way; now, however, like most advisers, he expects the market to move sideways:

“I don’t think we’ll get another 20 years like the last 20.”

He argues that even after a three-year bear period, the market is not cheap and is not down to single-digit P/Es. Dampier points out that in the period between 1962 and 1981, the Dow Jones moved sideways, rangebound between 700 and about 1000. There was, however, money to be made by trading the market or within a sector; thus in the past year, although the FTSE 100 has drifted, the mining sector has advanced. But if the index remains between 4000 and 5000 over a long period, index funds may not make any sort of return.

Connolly responds that if the prevailing view is that the index is going sideways, this is a sure sign that markets will move up or down. John Scott & Partners does not know which way things will go, and spreads its bets to cover the different scenarios.

But Dampier dismisses the tracker-based approach formulated by the pension consultants. “They’re the worst bunch of idiots you could ever imagine. They’re all sheep-like to say the least. The Government endorsed trackers in 2000 – as if that wasn’t the biggest sell note you’ve ever seen.” However, he concedes that index funds are
preferable to the huge and poorly performing insurance-managed products.

Although it is not easy to find consistently outperforming active managers, Dampier says that with a little foresight this can be done:

“There is a long list of managers who on the whole do pretty well.”

He likes Neil Woodford and Jupiter’s equity income manager Anthony Nutt for their tremendous form over the past few years.

Even if one manager does badly over one year, at least with four or five active managers employing different styles of investment within a portfolio, investors will not have all their eggs in one basket.

Trackers, by contrast, are a one-way, large-cap-dominated bet.

Most of the fund strategists interviewed argued that they were able, and had the research back-up, to pick outperforming active managers.

David Scott, financial consultant at Alan Steel Asset Management, says: “Our job is to spot the winners of tomorrow.” Anthony Bolton, for example, has returned around 11% a year over the past five years, and that in a period of falling markets.

Chelsea’s Schooling says it is difficult to know what the market is doing. But if it is going sideways, investors need to buy actively managed funds to outperform. She also maintains there are managers with the skill to outperform consistently: Bolton is one; Nigel Thomas, manager of Framlington UK Select Opportunities, is another.

Bowes, also, puts her faith in Bolton, Woodford and Credit Suisse’s Bill Mott.

Neil Ledbrook, provider campaign manager at Sesame, says he would rather pay 1.5% for decent returns from an active fund than buy an investment that automatically underperforms the market. He would trust a string of managers to deliver market-beating performance, including Bolton, Nutt, Woodford, Philip Gibbs of Jupiter Financial Opportunities and most of the Artemis team.

Gilligan says he is able to select active funds that outperform even after fees. He has used one tracker recently: the Edinburgh UK Tracker investment trust, where he expects a narrowing discount to boost performance.

So specialist investment advisers all claim they can more or less consistently choose outperforming active funds in an area where most pension fund managers feel it is nearly impossible to succeed.

A number of questions arise. First, can investment advisers really come up with the goods, and have they managed to do so over the volatile markets of the past few years? Second, as most
intermediaries are not investment specialists, and do not have the necessary research to underpin their advice, are trackers preferable to buying expensive underperformance from active managers? Or should they buy instead into even more expensive funds of funds, which will do the work for them?

A strong case can be made in favour of passive funds, at least for a proportion of client portfolios. Fee-based advisers such as
Bloomsbury and John Scott & Partners are enthusiastic, and pension funds too have thrown their weight behind this investment style.

But passive funds offer advisers virtually no commission, and therefore no incentive to sell the product. Over 90% of advisers in the UK are still paid by commission. If the whole industry moved towards fees, as has happened in the US, would index trackers be sold a lot more?

Charges and tracking error
Looking for an index-tracking fund for a client? There are only two selection criteria – charges and tracking error – but one can have a dramatic impact on the other. Compared with active funds, passive portfolios are particularly cheap to run. Transactions are
computerised; there are no fund managers to pay and no expensive research habit to feed.

Some funds pass on the low costs to the investor. M&G’s All-Share index tracker and Liontrust’s Top 100 fund charge just 0.3% a year, with no initial fee. Bulk purchasers – such as intermediary firm John Scott & Partners – manage to squeeze providers down to just 0.2%.

At the other end of the scale, the Scottish Amicable FTSE 100 tracker – from the same stable as M&G – has an annual charge of 1.45%, with a front-end load of 4.75%. M&G hastens to point out that charges are set to fall when the fund merges with another from the Prudential range. However, the fund is one of a number clearly making a huge margin at the expense of the investor.

As a result of the high charges, the ScotAm fund has a 2.08% tracking error against the benchmark FTSE 100 index over three years. It has underperformed the market by more than 50% over that period (see table on page 21). A number of other factors govern tracking error, including fund size, tracking methodology and the speed with which funds realign themselves to changes in the index.

Alan Harding, head of investments at Lloyds Private Banking, favours the M&G fund for its large size and consistency. He says smaller, less well-established funds have a wider tracking error. The Sesame fund researchers like the £2.4bn Legal & General UK Index fund for its size, low tracking error and total expense ratio. The company says the larger the fund, the smaller the effect of fixed charges.

Managers of the larger funds, such as L&G and Barclays Global Investors, have spent considerable time and attention refining processes – getting, for
example, their sampling methods just right. They are big enough management houses to be able to keep costs down by trading internally between funds.

The tables show, perhaps surprisingly, that over the past three years All-Share funds have had a smaller tracking error than those that concentrate solely on the FTSE 100. The superior performance of the broader index products is unexpected, as FTSE 100 funds tend to replicate the entire index with the right weightings, while the All-Share investments often merely sample the small and mid-caps to approximate the index. (They replicate the top 100 fully, and buy representative shares to approximate the rest of the index.)
The more efficiently the fund accommodates new cashflows, the lower the tracking error. And how the tracker adapts to companies entering or leaving the FTSE 100 at the end of the quarter makes a difference too. With active managers aware of these index changes, and out to make a quick profit, passive fund managers have to devise clever trading strategies to rebalance their portfolios.

Before investors go ahead and buy a tracker on the basis of the performance tables, however, it makes sense to ensure like is being compared with like in relation to measuring performance. Take, for example, the M&S UK 100 Companies fund: part of its 1.99% tracking error is due to high management costs, and part is down to the fact that the fund price is taken at 8am, but compared with the close of the FTSE 100 index on the same day. Market volatility can affect tracking error significantly.

Worldwide index management specialist BGI no longer offers
conventional unit trust index trackers to the UK retail market, instead focusing on its index-tracking exchange-traded fund products, called iShares. The 0.4% fund charge for the FTSE 100 product is competitive. And unlike conventional trackers, ETFs allow investors to buy and sell the market throughout the day. Shares are traded on the London Stock Exchange and can be shorted.

But Jason Butler, managing director of Bloomsbury Financial Planning, says he prefers All-Share trackers, as there is not an ETF that covers small-caps.