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."
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.
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
Investment trusts are companies that invest money in other companies and whose shares are listed on the London Stock Exchange. As with unit trusts, private investors buying shares in an investment trust are buying into a diversified portfolio of assets (to reduce risk), which is managed by a professional fund manager. Investment trusts differ from unit trusts in two important ways: they are listed on the stockmarket and so are owned by their shareholders and are closed-ended funds with a finite number of shares in issue. This means the share price of investment trusts might not reflect the true value of the assets in the company (known as the net asset value, or NAV) and if the NAV value of a share is £1 and the share price in the market is 90p, the trust is said to be running a discount of 10% to NAV. But this means the investor is paying 90p to gain exposure to £1 of assets. Investment trusts can also borrow money and use this money to buy investments. This is known as gearing and a geared trust is thought to be more of an investment risk than an ungeared one.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
Total expense ratio
Most investment funds levy an initial charge for buying the units/shares and an annual management fee but other expenses also occur in running the fund (trading fees, legal fees, auditor fees, stamp duty and other operational expenses) which are passed on to the investor and so the TER gives a more accurate measure of the total costs of investing. The TER is especially relevant for funds of funds that have several layers of charges. Unfortunately, investment fund companies are not obliged to reveal TERs and many only publish the initial charges and annual management charge (AMC).
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
A standard by which something is measured, usually the performance of investment funds against a specified index, such as the FTSE All-Share. Active fund managers look to outperform their benchmark index. Cautious fund managers aim to hold roughly the same proportion of each constituent as the benchmark, while a manager who deviates away from investing in the benchmark index’s constituents has a better chance of outperforming (or underperforming) the index.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
Active managed funds
These funds try to produce returns superior to a “benchmark index” such as the FTSE 100 by a combination of picking the right stock at the right price at the right time. A fund manager calls the shots and tries to outperform the index. “Passive” or “index tracking” funds just try to match the index as closely as possible and are managed by computer.