Comment: Trackers put the squeeze on managed funds

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Are you an active or a passive investor? Barely a month passes without further evidence of the growing popularity of index-tracker or passively-managed funds and trusts. Passive funds have been growing in vogue due to their cheapness – lower management charges – and simplicity of concept: no complex explanations of investment approach and philosophy.

As stock markets, boosted by ultra-cheap central bank money pumping, have risen in the UK and US particularly, it has been more difficult for managers to differentiate themselves.

At a recent Morningstar Investment conference, Katherine Garrett-Cox, chief executive of the Alliance Trust, said on the Alliance Trust Savings investment platform seven out of the top 10 selling funds were passive.

In 2013, she said, the most popular funds on the platform were actively managed. Last year there was a shift and the top selling funds are passive. “People”, she added, “have lost faith in active management in part because of fees. What you pay for a fund matters – it affects long term returns.”

Her remarks seem to be borne out by latest figures from the trade body the Investment Association. While private investors cashed in a record £1 billion from UK funds in March, the figures also showed the highest ever inflow into tracker funds. The total amount held in passive or tracker funds has broken through £100 billion for the first time, comprising 11.5 per cent of funds under management, compared with 9.8 per cent a year ago.

The arguments for and against both approaches have been widely aired. Actively managed funds and trusts have struggled to beat the underlying indices of the markets in which they are invested – so why put up with those management charges?

But index trackers, say critics, have a fundamental flaw. Index matching funds effectively result in investors buying indiscriminately at the top, and do not permit buying in downwaves and dips. And they are heavily invested in the largest companies by market capitalisation – not necessarily the best performers. These can be vulnerable to market “corrections”.

But do actively managed funds need to be more expensive? Garrett-Cox does not believe so. Active management, she argues, can be achieved at a lower price point. This is the new charge cap applied on pension funds. Many active managers have said they are unable to run money for this price. But a notable trend in recent years is for annual management charges to be reduced towards this level.

Many investors have resolved the argument in a simple and pragmatic way. A typical private client nest egg will have one or two index-tracker of passive funds at the core, with actively managed and specialist funds and trusts at the periphery.

As market conditions change they can change their active fund portfolio weightings by geography or asset type – more, say, in commodity or property funds, or those offering greater exposure to smaller companies.

Most investors – including those more heavily exposed to actively managed funds and trusts – have historically been passive investors at heart. They rely on the portfolio managers to do the investment switching and adjustments to overall market exposure. However, there are many equity funds and trusts that as a matter of policy do not ‘go liquid’ to any significant extent – that is, holding more than five per cent in cash and/or fixed interest. The argument here is that if an investor has chosen to invest in an equity fund it is not for the manager to opt to invest other than in equities.

However, attitudes are changing. The combination of two punishing bear markets since 2000, a notable increase in volatility since the 2008-09 financial crisis and the greater ease of buying and selling with the rise of index tracker funds – there are now 116 such funds – has resulted in a notable shortening of the average time period over which an investment is held.

“There is a worrying trend among some investors”, says Garret-Cox, “to want positive returns within a week of investing. From 1940 to 1970 the average holding period for an investment was seven years. After the credit crisis this dropped to just seven months. Now it is around two years – but for many asset classes this is not a long enough horizon.”

One reason older investors choose to hold on to their investments for a longer period is a reluctance to crystallise a Capital Gains Tax liability. A portfolio nurtured over the years can show impressive paper profits that investors may be reluctant to impair by an unnecessary sale triggering a CGT payment. All the more reason why investors need to guard against the creep towards low-performing stasis.

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