Tracker funds

What, exactly, is the point in stock-picking investment funds when perfectly good trackers are available? Nigel Davies finds out

Why would anyone buy into an actively managed equity fund? Think about the concept: you are paying for the expertise of a stock-picker so that he (it usually still is a he) will beat all the other expert stock pickers in the market. Most of the market is made up of passively managed funds that just buy a representative sample of the market and remain content with the dull-but-predictable returns that follow. So the deal you’re implicitly buying into with a stock-picking fund is that the expert you’ve chosen will beat the minority of other experts who do the same thing for the asset management firm down the road.

Since the bulk of the market is made up of passive trackers, and there is so much instant expertise available to the stock pickers, active management starts to look like a classic zero-sum game where one manager’s gains simply mean another’s loss – right up until it is his turn to lose.

The elusive Alpha

And lose they do. Research has repeatedly been carried out which shows that the elusive ‘Alpha’ that active managers bang on about is, in fact, genuinely elusive in the long run. Sure, you get managers who do very well in one, two or three years. But any further out than that, and the research shows that they do not outperform in any shape or form.

There is another problem. Suppose you do come across a genuinely clever manager who can, mirabile dictu, outperform on a regular basis (let’s say he has a sliver of golden market intuition that’s sadly absent in his peers). Pretty soon, he is going to be poached by a rival firm offering him bigger bucks to do his stuff. That, you will be unsurprised to hear, is precisely what happens time and time again. The firm he previously worked for still markets itself as being able to produce superior returns, but the chap who produced them has been whisked off elsewhere. They don’t, of course, advertise that fact on their billboards.

There are other objections to the active management concept, such as whether it really is conceptually possible for stock markets to significantly outperform underlying economies consistently (think about it: it can’t possibly happen), but all in all, active stock-picking looks too dubious to many investors to go for.

Enter, then, the market trackers. Tracker funds, also known as passive funds, simply buy an equal weighting of the stocks that make up a market or a market’s index – the FTSE 100, Dow Jones or the Euro Stoxx usually.
IFAs recommend index trackers as a long-term investment because, of course, markets can go down as well as up.

As proof of this, Anna Bowes, investment manager at IFA Chase de Vere comments on her clients’ perspective: “They like them first of all because they are cheap. You don’t have to pay an upfront fee and the annual management fee should only be around 0.5 per cent – lower than active funds. They can become an important part of a portfolio, though they are not entirely low risk and should be part of a balanced portfolio.”

As investors are paying a small fee each year this means that a tracker fund’s performance should be just below what the index returns. That is the price you pay for a tracker – but you bought into the idea of predictable returns in the first place, right?

Some professionals maintain that actively managed funds, if chosen well, can have a place in a portfolio. Anthony Millers at Chase de Vere reckons that as the stock markets will ‘be going sideways’ for a few years, an active fund might be able to capitalise on the normal fluctuations.

“There’s a lot of uncertainty in the markets right now, and the consensus seems to be that markets will probably be dull for a while. There will be peaks and troughs, and funds that have good stockpickers will fare better over the next few years. Trackers can be a clever play, though, and if you’re talking about a 10-15 year horizon then it’s not an issue.”

Does that contradict the arguments against stock pickers? No, because Miller is talking about capitalising on short-term changes in markets, which pickers can exploit. It’s long-term performance they appear to lack. But who is a good stock picker and where is the guarantee against a poor performance in the long term? There’s the rub. In the next issue of Investment International, we’ll be looking at this whole issue in more detail.