Fund Manager’s Response

Legal & General has always advocated the use of both index-tracking and actively managed investments. The validity of a “core and satellite” approach is supported by academics and market practitioners alike, with many fund strategists accepting that this is a sound portfolio strategy.

Although we cannot comment on James Dalby’s asset allocation, as we don’t know the client’s objective, we are surprised that index-trackers are not included. The four main benefits to using an index-tracking fund in a portfolio are risk, performance, persistency and cost. In constructing a portfolio, the investor should look to maximise return while minimising the risks involved. Index trackers can be used to manage this risk/reward trade-off.

It is generally accepted that investment risk is made up of market risk and stock selection risk. If an index tracker, with just market risk, is added to a portfolio of funds with market and stock selection risk, it follows that the overall portfolio risk is reduced.

An active fund will try to outperform a benchmark index by making a stock/sector decision, which will be either right or wrong. An index tracker, on the other hand, doesn’t have that decision dynamic. The rational investor will always ask how much of a fund’s performance is down to the active manager and how much down to the market performance.

With a number of successful stock/sector decisions, a surplus return can be delivered over and above that achieved by the market as a whole. However, can an active fund manager consistently deliver these excess returns? How often have we heard an active manager who has outperformed announce that he or she is about enter a period of underperformance and investors should sell the fund? Normally, it is only after a period of underperformance that an actively managed fund is sold and an alternative bought.

A successful active approach is often down to an individual star fund manager, who may or may not stay. This persistency may affect the consistency of delivering excess returns. Even with a robust, disciplined and strict investment approach, the constraints of such a process result in a poor risk/reward payoff, with the “flair” associated with star fund managers unable to break through.

There are so many more questions that need to be asked of actively managed funds. They certainly have their place in portfolios, but so do index trackers.