Can actively managed funds beat trackers?

The age-old investment debate of active versus passive has recently had its cobwebs blown away by some interesting developments.

It has always seemed to be a 'them and us' industry: the passive players up against the alpha-seeking active animals, both firmly entrenched in their own space.

However, the looming retail distribution review (RDR), which in 2012 will change the way financial advisers sell investment products and put pressure on charges, has shaken up this conventional thinking.

Vanguard, a large passive provider in the UK, has revealed that not only does it want to crack the exchange traded fund (ETF) market, it also wants to launch some active funds here.

At the opposite end of the spectrum, Schroders, a traditionally active investment house, has told Moneywise's sister publication Money Observer that it plans to launch some passive funds.

The firm hasn't worked out if they will be ETFs or tracker funds, but it does know these will be unleashed before 2012, and it believes they won't damage its active franchise.

Robin Stoakley, head of UK retail at Schroders, reckons we'll see other active fund management groups follow suit in the run-up to the RDR.

The blurring of active and passive lines in the industry means investors will soon have a bigger choice of funds to choose from when building their portfolios.

So it's important to understand the differences between active and passive strategies and in what scenario one might be more suitable than another.

The active versus passive argument

The active versus passive argument goes something like this: active funds cost more, but there is potential for outperformance, while passive funds are cheap, but there's no potential to add alpha.

Other things to bear in mind for active funds are the challenge of selecting a manager who will beat the index and justify its fees, and the risk of the manager leaving.

Robert Davies, managing director of Fundamental Tracker Investment Management, says the average manager tenure is three years.

"The historic data you may look at to find a good active manager is a poor guide to future performance, so it's difficult to find a good manager. You're trying to discriminate between experts," he comments.

Stoakley admits that the badly run active funds offer very poor value and "unfortunately there are too many of those around".

However, in their defence, he states: "Good active funds offer excellent value, as there is no difference in price between the top and bottom quartile unit trusts. It's like a BMW costs the same as a really rubbish car. It's quite a unique industry in that sense."

Do your homework

The bottom line with the active approach is that investors must do their homework. "Active managed funds add another layer to investment decisions.

After selecting an asset class, the investor has to identify which managers are good and which are bad," says Adrian Lowcock, senior investment adviser at Bestinvest. Over in the passive camp, things are looking pretty rosy.

Steve Laird, principal of Carrington Wealth Management, says many of the new funds have reduced their tracking error, meaning they replicate their benchmark more closely, and Stoakley says prices have come down.

"Before Vanguard, passive funds charged the thick end of 1%, which is a rip-off for just using a computer," says Stoakley. There are no surprises with a passive fund, as it will just follow the index.

Passive funds best in developed markets

So one of the pitfalls is that it will follow a market south in a downturn, with no manager able to move into cash or bonds to protect investors' money. Experts largely agree that passive funds work best in the large developed markets, as it is difficult for active managers to add value.

"The best examples are large UK and US equities," says Patrick Connolly, spokesperson for AWD Chase de Vere.

"Here, information is so freely available that it is very difficult for active managers to spot and exploit genuine investment opportunities." Davies adds: "There are so many final and interim results and trading statements that there's a level playing field among investors.

If Tesco takes some analysts around its stores and gives them a briefing, they will still press release it straight after so everyone has that information and no one has an advantage."

If you compare SVM UK 100 Select (active) with HSBC FTSE 100 Index (passive), the former has managed to outperform, although not in 2005.

When you consider the big difference in the total expense ratio (1.70% versus 0.27% respectively), this fund is an example where the extra charge has paid off.

However, as Peter Robertson, head of retail at Vanguard, points out: "Consistent long-term outperformance with an active fund is rare. But if you minimise costs it's easier, as there's no 1.5% headwind.

"If everyone had a 15 metre headstart against Usain Bolt he would soon start losing." Away from developed markets, active funds can work well for less sophisticated emerging countries.

Lowcock says active funds are ideally suited for "sectors where there is a lack of transparency and information, as well as markets that may not be behaving rationally due to enthusiasm for the sector" and "emerging markets would fall into this area".

Even passive advocate Davies admits: "Anthony Bolton could do well and add value in China [with his new investment trust] as there the data is soft and an active manager can get the inside track on companies."

Active funds best for small caps

Smaller companies is also a tricky area for trackers. Vanguard launched a global small cap tracker in January, but there are very few, if any, passive UK small cap funds.

Even traditionally passive investment firms are hopping on the active bandwagon for this sector.

Courtiers Investment Services is one of a growing number of companies that actively puts together portfolios for their clients using passive strategies.

Investment manager Caroline Shaw admits that she has recently had to choose an active fund for clients who want smaller companies exposure.

"We chose an investment trust – Aberforth Smaller Companies – as it's cheaper than a fund and you have a board overseeing it. These guys do add value, as the market isn't heavily researched.

"If you really wanted a passive strategy for small caps, you could go long FTSE All-Share and short the FTSE 100, but then you would still have mid-cap exposure, so it's not that clever really."

She says if she wanted a China or US small companies fund she would also take the active route. "We saw a manager of a US small and micro cap fund. That's really entrepreneurial, and we believe you can add value there with the active approach."

However, she does use a passive strategy for general emerging markets. Robertson is also suspicious of the long-held belief that active is better than passive here.

"It's all very well to say an emerging markets manager will outperform because they know what's happening on the ground, but very few active managers can say whether you should be in Chile, China, Brazil or wherever. They typically only know about one country.

"How can a manager cover the whole of emerging markets when normally they would cover just a sector in a developed country?" he argues. "If you're looking for broad emerging market exposure because you're not sure what country to go for a tracker is probably more suitable."

Robertson does have a vested interest though, as Vanguard offers an emerging markets tracker. However, it's Vanguard's largest passive fund in the UK, so it seems many investors agree that a passive approach can work in this region.

Vanguard launched its tracker last year, and over the past six months it has returned 15.4%. The average active emerging markets fund has returned 13.7%. The top-performing fund delivered 18.3%, so there's not exactly much in it.

Grey area

Mid caps are a grey area. The HSBC FTSE 250 tracker has beaten the Schroder UK Mid 250 fund over every time period. Over seven years the tracker delivered 155%, while the Schroders fund returned 116%.

Davies quips: "Andy Brough [the Schroders manager] should have taken his fund, at 1.5% annual management charge, seven years ago, invested in the HSBC Tracker at 0.5% and gone fishing for seven years living on the 1% margin.

"All his stockpicking skills over that time, and he is good, still haven't closed the gap."

According to Stoakley, the mid cap index is hard to replicate with a tracker, as there are a lot of stocks moving in and out, but he admits it's also hard for an active manager to add value.

This is an area where an investor's preference for active or passive may come into play and where a lot of homework is needed to pick a decent active manager or the right passive fund.

And what about bonds? The challenge with the passive approach here is the sheer size of the indices. Vanguard's global bond fund has trouble housing all 12,000 bonds from the Barclays index, so it settles for holding just 4,800 of them.

Most of Vanguard's active funds in the US are bond funds and Robertson says it intends to launch some low-cost active bond funds on this side of the pond soon.

Stoakley is firmly in the active camp. He explains that if you track a gilt index you will, by default, hold more of a country that is issuing the most gilts.

And which countries are likely to issue more gilts? The ones trying to plug their deficits, so hardly the most stable of nations.

Lowcock adds: "Little is known about future interest rate movements and inflation, and even downgrades of company ratings can be unclear. An active manager can filter this market to identify anomalies that occur."

However, some investment advisers are happy to use passive bond funds. Courtiers uses ETFs, and Laird is increasingly using passive bond funds. He notes: "As with equities, some active managers justify their charges and take advantage of market inefficiency.

"But given that returns on bonds are generally lower than those from equities, it is harder for active bond managers to justify their keep."

The active/passive debate is clearer cut for other investment strategies: investors hankering for an absolute return or best ideas fund, will have to take the active route as there are no passive alternatives.

It is also clear that we will see more passive funds popping up over the next few years and investors increasingly tuning into them. Advisers will embrace active asset allocation, but use passive funds to keep costs down.

"The active versus passive debate is an important one, although it should not be forgotten that the main determinant of investment returns is the asset allocation strategy. First and foremost, getting the asset allocation right needs to be the major priority," comments Connolly.

Laird adds: "Active asset allocation, combined with a greater use of passive funds, will be the real growth area going forward. I am always happy for a client, as I am myself, to pay additional costs where they can be justified by outperformance, but not otherwise."

This article was originally published in Money Observer - Moneywise's sister publication - in April 2010

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