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.