Does paying high fees guarantee quality fund managers?
The word 'passive' has plenty of negative connotations: think of 'couch potatoes' versus sporty types. Yet in the world of fund investing, passive funds are not only giving active funds a run for their money, but are exposing the latter for the damage that fund managers' fat fees can do to a saver's wealth.
Passive funds are essentially those where your money is invested in shares that track an index of stocks such as the FTSE 100, FTSE All Share or the S&P 500 in the US, with computers minding your money instead of expensive teams of managers.
Some achieve their remit by replicating the shares in an index, others by sampling. Exchange traded funds (ETFs), passive funds which trade like shares, also allow investors to track the price of more unusual assets, from gold to cocoa or wheat - and they have been increasing in popularity.
Critics say passive funds are a 'cop-out' as they can never beat the index or price they are tracking, and will follow it down as well as up, whereas active funds aim to outdo their benchmark and guard against falls.
However, despite recruiting highly paid managers, huge numbers of active funds end up trailing far behind the indices.
A market of weaklings
Andrew Wilson, head of investment at Towry Investment Management, believes "investors would be better off using a pin" than trying to trying to select an outperforming fund manager.
Using research from Reuters Lipper Hindsight into IMA UK All Companies funds over the five years, to the end of December 2010, he compared their performance against L&G's UK Index fund, a popular retail tracker.
The worst performer - Gartmore UK Alpha - returned minus 15.81% over the period, 44.3% worse than the L&G tracker, which returned plus 28.5%.
Wilson had to scan scores of names before he stumbled on an active fund that even matched the L&G tracker's performance. Among the losers were Templeton UK Equity, which fell by 8.71% in the period; Invesco Perpetual UK Growth, which only returned 3.28%; and Artemis Capital, which was up just 2.67%.
Figures from fund analysts Trustnet also reveal that while there are some impressive athletes in the active management arena, the market is so full of weaklings that even the worst-performing passive funds can put this group to shame.
The war on costs
A further drag on active fund performance is the costs of regular trading. Terry Smith, the City maverick waging war on high charges with his own low-cost fund, Fundsmith, says the average active fund turns over 80% of its portfolio in a year, at a cost of up to 1.5%, on top of other charges, shrinking investors' returns.
While outperformance is not possible for passive funds, their low charges make them popular with budget-conscious investors.
For example, if you invested £1,000 in a fund with a 0.22% total expense ratio (TER), assuming growth of 7% a year, you would lose just £456 (6.3%) of the returns in charges over 30 years; in a fund with 2.2% TER, however, you could wave goodbye to a staggering £3,530 in charges - 46% of the return.
But passive funds don't automatically come cheap, as the evidence of the Halifax Tracker fund's performance shows. In tracker land, it has a high TER of 1.5% compared with 0.36% for the top-performing Scottish Widows UK All Share Tracker. The rule of thumb is to avoid trackers with TERs of more than 0.5% to 1%.
While mediocre managers are clearly not worth their fat fees, there is an elite band that experts say delivers consistent performance. For Ben Yearsley, investment manager at Hargreaves Lansdown, this includes Neil Woodford at Invesco Perpetual; Ashton Bradbury and team at Old Mutual; Angus Tulloch at First State; and Hugh Young at Aberdeen.
Justin Modray, founder of website Candid Money, includes in his top picks the whole of Aberdeen's emerging markets team; Harry Nimmo who runs Standard Life UK Smaller Companies; and Nick McLeod-Clarke of Blackrock UK Income.
He says: "Managers who beat the index are worthwhile. But as there's no guarantee they'll continue to do so, it's important to understand how they have managed to outperform - whether through lots of stock picks or a massive bet on a certain sector."
Low-cost funds more popular
Modray says passive investing has an important role to play in certain markets: "Active managers tend to struggle in well-developed, efficient markets, such as the UK and US. It's usual for less than half the active managers in the UK All Companies sector to beat the FTSE All Share Index."
Andy Clark, managing director of wholesale at HSBC Asset Management, agrees that passive funds are more appropriate for developed markets but supports active funds for emerging markets.
So passive funds should stand alongside their active counterparts rather than simply replace them. Robert Talbut, chief investment officer of Royal Asset Management, describes this as the "core/satellite" portfolio approach, with passive funds at the centre and well-chosen, juicier active funds as the satellites.
The arrival of the post-retail distribution review (RDR) regulatory regime in 2013, which means commission will no longer be paid to independent financial advisers, is expected to spur sales of passive funds. Their simple, transparent cost structures will be easier for advisers to explain to fee-paying clients.
Currently, there's no commission paid on passive funds, meaning there's little incentive for IFAs to sell them - probably one reason why there are only 71 trackers out of 2,000-plus unit trusts currently available.
As a result of the RDR, the costs of passive funds have been falling. (HSBC Asset Management cut its charges to 0.25% across its range of nine tracker funds two years ago.)
Another stimulus has been competition in the form of US investment giant Vanguard, which launched in the UK in 2009. Its low-cost passive funds have TERs of 0.25%.
But there has been only muted response among active managers to these threats, although in February JP Morgan Asset Management did revamp its Active 350 fund (re-named the Active Index fund), reducing the annual charge from 1% to 0.25% and capping the TER at 0.55%, while in mid-March Schroders launched a low-cost fund (the UK Core fund) with a maximum TER of just 0.4%.
Investors, however, continue to be price-conscious. The Investment Management Association's figures for December 2010 show trackers gaining ground, with net retail sales for index tracker funds in the UK All Companies sector the highest on record at £143 million.
This is in addition to the enthusiastic activity in the ETF market, where the worldwide market (at $2 trillion) is booming, driven by a taste for more transparent passive investments that are also easy to trade.
However, Modray says: "I doubt we'll see a price war; there's little incentive for fund managers to cut costs. Until customers start demanding lower charges and threatening to move to better deals, most fund managers will sit back and count their money rather than reduce their fees."
Watch out for 'closet trackers'
Investors also need to be wary of the 'closet trackers' - giant funds that cream off big charges but offer little more than tracker-style performance.
Justin Modray, founder of financial information website Candid Money, says: "Closet trackers tend to hold stocks in similar proportions to the index and typically underperform each year, due in no small part to their annual management charges. The managers tend to sit on the fence and avoid taking bets against the index.
While this reduces the chances of making a big mistake, it also reduces their chances of beating the index. These funds are generally peddled by the large banks and insurers."
Closet culprits sitting on mountains of savers' cash include Prudential UK Growth (£2.4 billion); Scottish Widows UK Growth (£1.7 billion); Halifax UK Growth (£1.6 billion); and CIS UK Growth (£1.2 billion), which all underperformed the FTSE All Share over five years.
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%.
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.
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.
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 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.
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.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.