Warren Buffett’s a fan, but do trackers beat active funds?

Tracker or passive funds, which blindly follow the up and down movements of a stockmarket, have been selling like hot cakes over the past couple of years.

According to the Investment Association (IA), retail investors hold £110 billion in tracker funds - 13% of the total invested.

Three years ago the figure stood at £75 billion, while in 2007, before the financial crisis struck, the amount held in trackers was a mere £29 billion, which at the time represented 6.3% of the total.

There are various drivers behind the tracker fund sales boom, but the fact that they have become much more popular since the financial crisis is not a coincidence.

During the crisis, from September 2007 to April 2009, the average fund in the IA UK all companies sector fell 40%, according to FE Trustnet, in line with the losses posted by both the FTSE 100 and FTSE All-Share indices.

But for some investors, the fact that active fund managers were not able to give a better account of themselves was enough to undermine their faith in active management.

There have also been various academic studies over the past couple of years that have shed a poor light on active funds' ability to add value.

Even Warren Buffett, one of the world's greatest investors, is sceptical about the merits of active funds.

He has instructed the executors of his will to buy an index tracker for his widow. He has selected his preferred choice - Vanguard's S&P 500 index fund.

Lower costs, with some tracker funds charging less than 0.1% versus typically around 0.9% for an active fund, is a key attraction.

Simplicity is another: investors - particularly those who are younger - favour the certainty offered by a fund that will do what it says on the tin. With active funds, in contrast, investors hope the manager outperforms the index.

According to broker Hargreaves Lansdown the proportion of trackers in the portfolio of an investor in their 30s is three times higher than for someone in their sixties.

Adam Laird, senior analyst at Hargreaves Lansdown, explains the reasons behind the trend: "When you buy a FTSE 100 tracker it's easy to find out what it invests in and simple to follow its performance.

"This is one of the reasons why tracker funds appeal most to new investors or those who can't dedicate the time to research dozens of active managers."

Experts, however, caution against using passive funds in isolation. Philippa Gee, a financial adviser, prefers to mix and match, investing her clients' money in both active and passive.

"I believe in both styles. Some portfolio advisers tend to stick to one type of solution only; however, all the research I have personally conducted points to certain markets and certain situations suiting a passive approach and other sets of markets and news feeds suiting active management."

Money Observer conducted research examining how passive funds have fared versus active in various equity markets. We looked at six major geographical IA sectors - UK all companies, Europe, North America, emerging markets, Asia excluding Japan, and Japan.

A five-year time horizon was chosen, because during this period there has been a range of market conditions. Using data sourced from FE Trustnet, we then calculated how many active funds beat the best-performing tracker fund in each sector, converting this figure into percentage terms.

There are certain markets where active funds have held their own since May 2011. We found active funds in Europe fared best, with 74% of active funds beating the best tracker, while active also gave a strong showing in the UK all companies (68%) and emerging markets (61%).

In contrast, active funds that reside in the North America sector struggled to gain an edge, with only 12% managing to beat the best tracker, while Asia ex Japan also underwhelmed (33%). For Japan the percentage of active funds beating the best tracker was 53%.

Research by BMO Global Asset Management also offers plenty more food for thought on the debate between active and passive.

Rob Burdett and Gary Potter, who have been multi-managers for two decades, looked at how tracker funds and active funds performed in six regional equity sectors over the past decade; they concluded that it is "still worth trying to find the small number of fund managers who can consistently outperform the stockmarket".

For each month over the 10 years to December 2015, Burdett compared the performance of every fund in each of the six sectors against the benchmark most commonly tracked by passive funds in that sector. So, for instance, for the equity UK sector the FTSE All-Share index was used.

As the chart above shows (click to enlarge), in rising markets over the past decade, active funds in every sector underperformed their sector index. Burdett puts this down to the tide of quantitative easing "lifting all boats", which in turn has made it "a tougher stock-picking environment".

But in falling markets active funds outperformed, with the sector average beating the relevant benchmark in five of the six sectors. The exception to the rule was US equities, further evidence that active managers in this sector struggle to gain an edge.

"Many investors choose exclusively between holding passive or active funds, often citing the higher fees of active funds as off-putting," says Burdett.

"We have always held the view that if you pick the right active fund, the excess performance should easily compensate for the extra 0.5% or so of annual cost."

Burdett adds that the fact that active funds fare better in falling markets is not a surprise. He says fund managers can outperform at times of heightened volatility by simply avoiding certain sectors and shares. Trackers cannot do that.

However, he holds the view that passives can have an important role to play in a portfolio as a means of reducing overall cost and adding diversification.

The five funds in his and Potter's F&C Multi Manager Lifestyle Foundation range typically hold between 20 and 25% in tracker funds.

Burdett says the most heavily weighted to passive is the US element, pointing out that US active funds struggle because the S&P 500 is one of the most efficient stockmarkets in the world.

The lowest passive weighting is to the UK, partly because he does not like the composition of the FTSE 100 index, which is heavily skewed towards certain sectors.

There is less of a pro-tracker case in more niche markets. For those who want exposure to a specific industrial sector or geographical region, there is a shortage of tracker fund options.

Trackers are also viewed as less efficient in fixed income markets, and less useful as an income proposition, as, by design, they will simply offer the market yield. Nonetheless, in mainstream markets the tracker versus active debate will no doubt continue for years to come.

The aim of every investor should be to cut their costs to the absolute minimum, while seeking out the fund managers who are most likely to outperform the market.

But when it comes to tracker funds, do not make the mistake of thinking they are all cheap.

Tracker funds can cost less than 0.1% a year, but some charge 10 times this amount. For example, the Virgin UK Index Tracking fund, which holds £2.4 billion in assets, costs an expensive 1%.

Other funds that charge over the odds include Halifax UK FTSE 100 Index Tracking (1%), Marks & Spencer UK 100 Companies (1.03%) and Henderson UK Tracker (0.74%).

The higher the charge, the more handicapped each tracker is in trying to keep pace with the index it is blindly following.

For the UK, the cheapest fund that tracks the FTSE 100 is Legal & General UK 100 index tracker at 0.06%, but this price is only available through Hargreaves Lansdown. Elsewhere the fund costs 0.1%.

HOW THE EXPERTS MIX AND MATCH BETWEEN TRACKERS AND ACTIVE

We asked two experts how they blend a mixture of active and passive funds in a balanced portfolio.

Tom Becket, chief investment officer at wealth manager Psigma, says: "Our overriding belief is that there are times in the investment cycle to be more positive on passive instruments and others when active could work better.

"Having spent much of the last eight years feeling that passive investments had just as much chance of doing well as active, we have recently taken a more positive view on active funds, particularly those that have a concentrated portfolio and a high-conviction approach.

"The chief reason behind this switch in mentality is the increased bifurcation we are seeing within stockmarkets, as those companies that deliver positive results are rewarded and those that fail to hit expectations are punished.

"We also recognise that expressing a specific theme, such as our current passion for value strategies, is much easier through active funds."

Mike Deverell an investment manager at wealth manager Equilibrium, says "In equities, we currently hold less in index trackers than usual and more in active funds, and there are several reasons for that.

"In the UK, for example, we prefer smaller companies. They look better value than large companies, trading on lower valuations and with greater profit growth.

"It is difficult to access smaller company index trackers and our research shows that active managers definitely can add value in UK small cap, while it is less clear cut in large cap. We therefore allocate more to active UK equity funds that have a small-cap tilt."

This article was originally published by our sister magazineMoney Observer here.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser