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Can low-cost funds fulfil their promise?
In the argy-bargy between active and passive, a new approach has emerged, which is neither exactly one or the other.
The newcomers are low-cost active funds and could be seen as the Goldilocks of the fund management industry, steering a course between the 'hot' of racy actively-managed funds, and the 'cold' of predictable passive.
The most vocal proponent of this new type of fund has been Terry Smith, who launched the Fundsmith Equity fund in November 2010. The fund was designed as a buy-and-hold portfolio of a small number (20-30) of 'high-quality' global branded companies. The fund has a total expense ratio of 1.17% for direct investors, about 0.5% lower than a typical fund in the IMA global sector.
Schroders and JPMorgan also brought funds to the market in 2011.
They set themselves relatively low performance targets - for example, 1.3% above the FTSE All-Share index for the Schroder UK Core Fund - and costs are substantially lower at just 0.4% per year for the Schroders fund and 0.55% for the JPMorgan fund. Investors could therefore expect to see the performance of the index, plus a bit extra, at a cost that compares well with passive funds.
HSBC and Fidelity have also recently launched lower-cost funds, but both are portfolios of ETFs or other tracker funds, that aim to add value through active allocation to different asset classes.
This new type of fund goes against current investment fashion that claims the best way to run portfolios is to hold concentrated funds with 'high conviction' ideas or to go for as-cheap-as-possible passives.
Mike Parsons, head of UK distributor sales at JPMorgan, says: "Our view is that people aren't wedded to passive funds philosophically and would like some active bets round the outside. But the UK Active Index Plus fund is not a 20-stock, 'best ideas' type fund - these active bets against the index are relatively small."
Dr Robin Keyte, director at Keyte Financial Planning, points out that the concept is not entirely new: "There is talk about a 'new breed' of low-cost actively managed funds but what about those funds that have been around for over 100 years, some of which have annual TERs of 0.5% or thereabouts - investment trusts? That said, a new emphasis on transparency of mutual fund charges is very welcome."
The new funds certainly have the power to shake up the industry. Jason Ashman, director at financial advisers Chatfield Private Client, says: "Could it be that active fund managers have unwittingly just let the genie out of the lamp? What happens if the new low-cost active funds actually start to perform better than their more expensive stablemates? Now that is when the debate could really start to get interesting."
Any analysis of performance is inevitably limited because most of these funds have not been around for very long, particularly those from HSBC. However, so far the verdict would generally be 'mixed'. The Fundsmith fund has done extremely well. It delivered 15.7% in 2011, against an average drop for funds in the IMA global sector of -2.8%.
Partly, this is because last year's risk-averse climate saw investors favouring the large, reliable global brands in which Smith invests, but also because - in an uncertain world - people kept buying soap, pet food and loo roll.
Smith says: "We would never invest in a company that needs our money. We believe that in a difficult environment people will still brush their teeth, ride elevators and feed their pets."
The Schroders and JPMorgan funds target a smaller outperformance of the index and so were never likely to see similar returns.
That said, the JPMorgan JPM UK Active Index Plus has delivered in line with its objectives since its launch in February of last year. It is flat over one year, compared to a drop of 1.8% for the average fund in the IMA UK all companies sector.
It is worth adding that the Vanguard UK Equity fund - a passive fund - has delivered the same performance, suggesting the amount generated by active stock selection in the JPMorgan fund has been eaten up in the marginally higher fees.
The Schroder fund does not yet have a one-year track record, but is slightly behind the sector average since launch.
However, perhaps the biggest question for investors is whether these funds fall between two stools - neither as cheap as passive, nor offering the opportunity for outperformance of a traditional active fund.
After all, if an investor really believes that active funds can add no value, why bother with any type of active fund, be it low cost or not?
On the other hand, if an investor believes that the right active manager can deliver long-term performance, why tie his hands?
As Steve Laird, senior partner at Carrington Wealth Management, says: "Looking at just one of the 'new breed', it doesn't appear to be producing any better returns than a tracker, so what's the point?"
Laird remains unconvinced by the concept: "I suspect that low-cost active funds are a marketing gimmick - designed to appeal to the cost-conscious who don't want to pay for full active management, but who believe a fund manager can add value with asset selection or less trading."
The drive to lower costs is certainly important. Minesh Patel, managing director of EA Financial Solutions, says: "Academic evidence has proved that the majority of active fund managers deliver less performance than stock markets and at a high cost. The high cost is made up of fees such as initial charges, annual management charges, performance fees and exit fees and has generally been damaging for investors."
Jason Witcombe, certified financial planner at Evolve Financial Planning, says: "Quite simply, costs are important and they are something that investors have within their control. If fund A charges 1.5% a year and fund B charges 0.5% a year, fund A needs to outperform by 1% - year in, year out - just to break even with fund B. As an investor, that is a bet I wouldn't want to take."
Equally, Terry Smith believes that most investors get a bad deal out of active funds and certain types of index fund can lack transparency, notably synthetic-backed ETFs, that are backed by derivatives.
Consistency to be proved
Certainly, low-cost active funds address some of the traditional problems with passive funds. They do not, in some cases, weight stocks in their portfolio by market capitalisation.
This means that they do not have the "yesterday's winners" problem of many passive funds. Equally, some human input into a strategy should ensure that the impact of an occasional troublesome stock - such as BP (BP.) - is minimised.
The funds also fit with the increasingly common view that active management is more suited to less efficient stock markets, such as those in the emerging world. Therefore, this type of fund may suit an investor who wants some chance of outperformance in the core of his portfolio, but doesn't want to spend a lot of money chasing it.
Parsons says: "It is easier to run this type of strategy in larger, more liquid markets such as the US or UK. Emerging markets have greater opportunities for active managers because there are more pricing anomalies."
Justin Modray, owner of website www.candidmoney.com, says in examining whether these low-cost active funds will deliver value, investors have to ask whether the manager in each case can consistently beat the index. If they can, these funds may be a bargain. They are certainly a better choice than some of the poor-performing, expensive active funds on the market.
They are low cost, they aim to be predictable; like the baby bear's porridge, they are not too warm and not too cold. But boring might not be the worst thing in the current environment and at least investors can be reassured that they are not paying high charges for rubbish.
As with any other fund, success will ultimately depend on the manager's ability to find the right companies.
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