Summing up: Time to get active on investments

HOW do you feel about driving along an unfamiliar road by looking only in the rear-view mirror? It’s probably pretty difficult, wouldn’t you say, if not impossible (not to mention dangerous)? Yet that’s precisely what investors are effectively doing when they place their faith in funds that track indices rather than actively managed funds that look for tomorrow’s winners (and not yesterday’s fat cats).

A growing number of pundits claim that there’s no point investing in UK active managed funds because “they’re too expensive” and because “only a minority manage to outperform the index”. At a pensions seminar I managed to stay awake long enough to hear a speaker say as only 25 per cent of active funds manage to beat the All Share index, it’s not worth the bother trying to find them.

Dear, oh dear. If you want to know why the tracking (or “passive” approach) is a recipe for underperformance you need only take a look at the FTSE All Share Index.

Most indices, the FTSE All Share included, are what’s known as capital weighted. This basically means the bigger the company, the greater its influence on index performance. The biggest companies, of course, tend to have their better growth days behind them, yet as a group dominate index performance. In the FTSE All Share the biggest five firms account for 22 per cent of the index, with the biggest 20 making up half of it. So that’s just 20 firms dominating the performance of more than 630.

Warren Buffett, the legendary US investor, says the most successful system of investing boils down to four words: buy low, sell high. So what does an index tracker do? It sells low and buys high. By the year 2000 Vodafone made up 9 per cent of the All Share. It was clearly overvalued but the higher it went the more the index tracker had to buy. This wasn’t a good idea, as investors found to their cost a few months later.

Joel Greenblatt, author of The Little Book That Beats The Market, said the best way to invest is to fish in the right investment pond. He added if you took a photo of any index on any given day, you’d find 50 to 60 per cent of the share prices would reflect fair value, while 20 to 25 per cent would be undervalued (for whatever reason) and 20 to 25 per cent would be overvalued.

So which pond should a manager fish if he wants the best chance of delivering future profits?

Obviously the undervalued pond – and then simply wait until these shares become overvalued. Then naturally you want to cash in your gains, but who’s daft enough to buy overpriced shares? Index trackers, of course. They have to.

But the number-crunchers insist that trackers are cheap. Erm, so were with-profits plans and Equitable Life plans, apparently. Personally, I’d rather find the best active managers and build a team of them to handle my savings with a balance between defence and attack.

A Barcelona FC equivalent, if you follow my drift. And who would be my first choice centre-half? Neil Woodford, formerly of Investec and now his own Woodford Investment Management. Over 25 years his flagship income funds have absolutely trounced the All Share Trackers, and that’s after all charges.

• Alan Steel is chairman of Alan Steel Asset Management Ltd

www.alansteel.com