Bill Jamieson: Hedge your bets on active versus passive funds

'We face a very difficult future. Finding value and retaining a robust filter is hard'. Picture: Getty Images

True, the FTSE 100 Index has more than made good the lost ground since January. Having tumbled to a 12-month low of 5,536, it has rallied strongly, gaining another 2.25 per cent last week to 6,343.75. Was there little for us to worry about after all? Or was it a harbinger of more storms to come?

There is a growing view that the period ahead may prove more unnerving than the opening three months. It is not just that uncertainties over the European Union referendum vote are testing market nerves. Nor is it confined to concerns over the earnings reporting season now upon us – in the US, markets are preparing for a slew of earnings downgrades.

There is also a widespread apprehension that the slowdown in the world economy is persisting, it is unlikely to be reversed any time soon and that central bankers are at a loss over the failure of monetary loosening to fuel a vigorous and sustained upturn.

Taking all these together, we may now be experiencing the end of a prolonged bull market for shares and entering a period of low growth, low returns – and a markedly vulnerable period for shares. Fund manager Simon Murphy at Old Mutual believes that the seven-year post-recession bull market has come to an end and that investors in UK stocks should be prepared for low returns and a volatile ride.

It seems just the sort of period when investors most feel the need for active fund management – to turn to experienced equity managers who can steer a portfolio through the hazards that look set to befall the passive index-hugging fund. But this may prove a dash to the heart of the fire.

Leading active fund managers may share apprehension about what lies ahead for markets. But their advice on where and how to invest over this period can be diametrically opposed. “Go for smaller companies,” says one guru. “Stick with big defensives,” says another.

Take the division of views between leading UK equity fund manager Neil Woodford and his iconoclastic rival Terry Smith, whose low-cost Fundsmith business has grown strongly in recent years.

Woodford told an investor briefing hosted by Jupiter Asset Management last week that markets are challenged, stocks are expensive and growth is subsiding – and all this against a backdrop of political and economic uncertainty. “The economy looks awful. We face a very difficult future. Finding value and retaining a robust filter is harder than ever.”

He said the only way to achieve returns for investors in the UK stock market was to stretch his investment approach and invest in businesses without cashflows – early stage companies where the demand for capital is “huge”. There are, he added, “only a few UK large cap opportunities out there, most is in smaller companies.”

Terry Smith, speaking at the same conference, hasn’t ruled out the global economy falling into recession once central banks begin to raise interest rates. Rate rises following years of money-printing could spark an economic slump, he said, but that it would be better than “continuing to stumble into a lost decade or two or three, which is where we appear to be heading at the moment”.

His Fundsmith Equity Fund has done well to take shelter in large defensive consumer staples companies. But critics now argue they have become too expensive. Smith concedes the sort of stocks he likes have become pricier, but argues that value has not gone away.

Either way, active fund management must have done better than passive investment. And don’t such funds do better in a bear market? But in the sharp market declines of the first quarter, just 19 per cent of US mutual funds that invest in “large-cap” companies outperformed the S&P 500, according to Bank of America Merrill Lynch – the lowest quarterly “hit” rate since data began in 1998.

Only 6 per cent of “growth” funds managed to beat their index, the worst rate since at least 1991. And value funds did badly too – just under 20 per cent beat their benchmark. “In short,” says Money Morning, “pretty much regardless of strategy, if you could have found a cheap tracker to pursue it, you’d have been better off in most cases than if you’d bought the active fund.”

A growing preference now is for portfolios to comprise a central hub of index-tracker funds, with spokes radiating out to specialist smaller company or overseas country trusts. Given all the uncertainties, it is hard to dispute its cover-all-bases popularity.