By STEPHEN MARRIOTT 04/11/2010
The market for trackers, especially Exchange Traded Funds (ETFs) has seen huge growth during the last decade. This trend has fostered the debate about the relative merits of passive versus active investing.
The aims of a tracker, or passive, fund is to mirror the performance of its benchmark index or market as close as possible. On the other hand an active fund manager looks to outperform the market whilst trying to reduce the risk of absolute losses.
The main debate is that many active fund managers fail to beat the market, with advocates of passive funds believing it is because most markets are efficient and the opportunity to exploit market anomalies is very rare. Proponents also believe higher costs of active funds drags down the returns relative to passive funds. The annual running costs – known as the total expense ratio (TER) - of index funds generally range from 0.3-1% compared to active funds which typically cost 1-1.75%.
Whilst it is true that the average fund manager has failed to beat their respective benchmark1 that is not the whole picture:
Cash and risk
Trackers are fully invested in all market conditions. Whereas some fund managers of active funds are prepared to use cash tactically and will alter levels depending on their view of the market. For example, in a bear market the ability to hold cash when the market falls can make a big difference to returns. A tracker might reduce risk relative to an index, but will not reduce absolute risk, due to its exposure to specific sectors that dominate some indices. Because an active manager has a choice on the investments in their fund, this risk can be reduced. E.g. BP, before the Macondo oil well disaster occurred, represented 7% of the FTSE 100 index, following the disaster the share price halved in this instance a FTSE 100 tracker would be fully exposed to this loss, whilst an active manager may not have been invested in the company.
Tracking error
Passive funds can never fully replicate the performance of the index they are tracking and there are discrepancies between the returns of funds that track the same index. Charges, transaction costs and the method of constructing a tracker lead to the discrepancy. E.g. Fidelity MoneyBuilder UK Index has a 0.1% annual charge, where as AXA UK Tracker has a 1% annual charge. Fidelity MoneyBuilder in the five years to the end of September has gained 22%, where as AXA UK Tracker gained 20% in the same period.
Cremers and Petajitso study
Fidelity International recently released a report, which highlighted a 2009 paper produced by KJ Martijn Creemrs and Antti Petajisto of Yale University. The study analysed 2,647 US equity funds in the period 1980 to 2003 and found that the most active funds (highest quintile of active funds based on investments away from the benchmark) outperformed their respective benchmarks by 1.13% per annum. The survey also discovered there has been a shift to ‘closet indexing’ – where fund managers take only small bets away from the benchmark. We have also seen evidence of this, especially among the larger funds and this, in part, explains why the average UK fund underperforms.
The best active managers add value
We have found, as the Cremers and Petajitso study suggests, that the exceptional managers produce superior returns by taking big bets away from their benchmarks. Often these managers add value in more specialist areas such as smaller companies; during the last five years the top performing funds in the IMA UK Smaller Companies sector outperformed the bottom performing funds in the sector by 64%. This is because good research pays higher rewards in less efficient markets. Therefore, we do agree that it is harder to outperform in the more efficient large cap dominated markets, the difference of returns between the top performing funds and the bottom performing funds in the UK All companies sector (which is dominated by funds that invest in large cap stocks) is 40%2.
In our view active and passive funds have their rightful place in a diversified portfolio; and we do recommend tracker funds where markets are more efficient.
Recommended Active Funds
Recommended Passive Funds
1 The average UK fund (as measured by the IMA UK all companies sector) underperformed the FTSE All Share by 7.9% in the 10 year period to 30/9/10 (Source: Lipper)
2 Data as at 30/9/10, Source: Lipper