Funds that passively track the market are less popular than those with active managers, who try to beat the market. But some say they offer more certainty for lower charges. Which should you choose? Niki Chesworth investigates.
Active approach: whether you choose a tracker or a managed fund, the key is to keep an eye on their performance
Warren Buffett, the investment guru, has said the best way for most investors to own common stocks is through an index fund that charges minimal fees, saying they will "beat the net results delivered by the great majority of investment professionals".
Tracker funds are not only a lower-cost way to invest — because they do not have the expense of paying a team of active fund managers — they offer the certainty of passively tracking a given stock market index. They therefore should not significantly underperform the market, something actively managed funds cannot guarantee.
So it may come as no surprise that the total amount invested in tracker funds managed by UK investment companies soared from £20bn in 2008 to nearly £28bn at the end of last year, according to the Investment Management Association (IMA).
But delve behind these figures and it's apparent this increase was not because these funds were increasingly popular with investors — merely a reaction that tracker funds track the market and the markets bounced back sharply.
Only 5.5pc of all funds under management are held in tracker funds according to the IMA but when it comes to sales, they are attracting just 2.5pc of individual investors' money.
With criticism in the media that investment charges are impacting on the performance of some actively managed funds – as well as reports that some active managers fail to match their benchmark index let alone beat it – why are passive funds not more popular?
"While trackers appeal to institutional investors such as pension funds and charities, which have long-term objectives and are in the main happy to accept market risk but at no more cost than is necessary, individual investors want their fund managers to deliver alpha, they want to beat the market," says Justine Fearns, research manager of independent advisers AWD Chase de Vere.
"Investors believe that if they pick the right active managers, they may be able to get that extra bit of performance."
Fearns also believes the poor sales of trackers is a reaction of the stock markets. She says: "Traditionally, trackers are used in more developed markets where news and information is readily available and it has been more difficult for active fund managers to consistently beat the market.
"In contrast, information is not always as free Ḁowing in underdeveloped markets, which creates more opportunity for active fund managers to beat the market.
"Similarly, in volatile and uncertain markets, like we have seen recently, individual assets can become mispriced, creating investment opportunity. This applies to both developed and underdeveloped markets and lends itself far more to an active stock-picking approach.
"If you know the market is going to perform strongly then you can get a good market return quite cheaply through a tracker. But when the markets start to come down, you will suffer the full effects of market falls with a tracker fund. So investors can tactically look to protect the downside with an actively managed fund."
Bearing the brunt of short-term falls in markets is one reason why those prepared to take a long-term view — institutional investors — may see the attraction of tracker funds better than individual investors.
Tracker funds have to blindly follow their given benchmark index which can cause sharp falls in the fund's value.
"This is the major drawback of tracker funds," says John Kelly of Chelsea Financial Services. "Even if the sector is overbought or likely to fall, the tracker has to buy it because it has to track the whole of the market."
Fearns says that low sales of tracker funds may also react investors' financial objectives.
"With interest rates low, many investors are looking for income from their portfolio and while a tracker will have an element of yield it will not match that paid by the best equity income and bond funds," she says.
The issue of tracker fund performance has also come under the spotlight. Some trackers buy shares in all the companies that make up the index they follow. Others use complex financial instruments to track that index. Although both types aim to track their benchmark, performance can still vary – and once charges are deducted there can be a consistent slight underperformance.
One recent survey found that while the FTSE All Company sector grew 372.50pc over the last 20 years, tracker funds showed just 330.9pc growth. However, much depends on which indices you compare — among the top 20 UK funds over the past five years is a mid-cap tracker which beat most of the 300 funds in the UK All funds sector.
However, the same claims of underperformance can also apply to actively managed funds – but with actively managed funds this can be far greater.
"There are some poorly performing active funds but if you do the research and get the right advice, you should consistently outperform the benchmark," adds Chelsea Financial Services' Kelly.
"However, with actively managed funds you do need to actively review them – ideally at least every quarter – as the funds you need to hold will change."
This is the key to successful active investing – it is vital to monitor your portfolio. Yet many individual investors fail to do this.
And performance also depends on what investors track.
Trackers are not confined to just the UK. It is possible to track global technology stocks, the global health and pharmaceuticals index and the major markets around the world — from Japan to the US and Europe — gaining access to sectors and geographical diversity for less than an actively managed fund and without the risk of buying the "wrong" fund that underperforms the benchmark.
So which is best?
"There is a place for both types of investment style – a tracker could provide long-term capital growth, but active managers may be able to outperform the market," says Fearns. "It's about balance — a balance of investments, risks and management styles."
However, investors who are passive about monitoring and reviewing their active funds may be better off with passive investments. John Kelly sums up the problem: "Inertia is the biggest destroyer of returns."
Written by Telegraph.co.uk as part of Smart Investment Month in association with Legal & General Investments
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