The Skoda syndrome

1 May 2010 Corporate Adviser

Talk to a mini cab driver and he will tell you that, under the bonnet, his Skoda is a Volkswagen in all but name - it just cost him around £5,000 less. VW drivers will argue otherwise, claiming that the extra £5,000 has been money well spent.

The argument is not dissimilar to an active fund manager boasting that his actively managed fund will leave its passive rival in its wake. The trouble is, as we all know, look under the bonnet of many active funds and you find they offer little more than cheap tracker alternatives.

Laith Khalaf at Hargreaves Lansdown says: “Default funds are often actively managed, but their managers can be hamstrung by benchmarking constraints which make them closet trackers. There is no appetite for any risk within a default fund, and deviating too far from the index falls into this category.”

The active versus passive debate is an old one, yet the revelation that some company pension schemes are charging ten times as much than the best value schemes has once again turned the spotlight back on the merits of active fund management.

It begs the question whether active management is actually worth paying for, both in the field of default funds and in the risk-graded recommended portfolios.

The whole market, by definition, is a loser’s game because while for every winner there’s a loser, the costs of the game are deducted before the players get their return

According to the report from the Department for Work and Pensions (DWP), charges on some company money purchase pension schemes are as high as 2 per cent of fund value each year, compared with an annual management charge (AMC) of just 0.15 per cent on the best-value schemes. Not all of this is down to fund management charges of course, but some is.

Yet, by and large, actively managed funds disappoint, leaving many wondering whether they are better off in passive funds, where costs are far lower and as such will have less of a detrimental impact on overall returns.

The index-tracking brigade reckon that many advisers are making that decision already.

“Many advisers have already worked out for themselves that basing their proposition on the hopes that their chosen fund pick would come good has turned out to be a recipe for some difficult client conversations,” says Nick Blake, head of retail sales at Vanguard.

“For evidence of the growing interest in index management, one only has to look at the ABI stats for the share of passive fund sales versus active fund sales - and the growing number of passive based fund of fund models being launched in the market. Two-thirds of pension plans use some form of passive management in their strategies and the trend is accelerating.”

New figures from Money Management, the monthly magazine, reveals that on a one-year basis the average fund tracking the FTSE All Share index has returned cumulative returns of £1,383 on an initial investment of £1,000, above the UK All Companies sector average of £1,339.

Of the 27 funds tracking the two main UK FTSE indices that posted one-year figures, only five underperformed this benchmark.

If you can demonstrate that you can regularly outperform a benchmark through actively tweaking the constituents of a given riskrated portfolio then all credit to you

Blake adds: “The whole market, by definition, is a loser’s game because while for every winner there’s a loser, the costs of the game are deducted before the players get their return. Many advisers understand this, but believe there are circumstances where seeking an active manager gives an opportunity to win the game.”

Matt Pitcher, a senior client partner at Towry Law, says: “There is increasing evidence that it is appropriate to use low cost passive funds in the major liquid investment markets where active fund managers struggle to outperform on average. US large cap equities and UK gilts are good examples of this. Active management can still be justified in less efficient markets where there is greater potential for outperformance.”

Yet question marks also hover over the theory that active fund managers will deliver better returns in inefficient markets such as emerging markets. The Money Management survey shows that this is not always the case - tracker funds also outperformed active managers in the emerging market space.

Several consultants wonder whether sector-specific funds are an issue for the DC market.

“While there will always be a minority of members wishing to pay contributions into a fund in a particular sector, the majority of members want someone else to make decisions for them.

This is leading to increasing popularity in diversified growth funds and absolute return funds rather than funds specialising in particular sectors,” says Helen Dowsey at Aon Consulting.

“Risk-rated portfolios will usually hold different asset classes for diversification rather than different sector funds. The equity funds will cover many different sectors and the decisions on which sectors to invest in will be within the control of the investment manager,” she says.

Blake, who has an obvious allegiance to tracker funds - Vanguard’s pitch is its low costs products which it is able deliver because of its huge size - argues that active fund management is only worth paying for if it is low cost.

“In truth, every market is still a losers’ game as all markets deduct costs before giving the return to the players,” said Blake. “In the US, the majority of default funds are target-dated funds using a passive strategy. With National Employment Savings Trust (Nest) looking to echo that low cost approach in the UK, the trend looks like it is gathering pace here too.”

Nest is certainly focusing attention on cost of pension schemes in the workplace. If Nest gets it right on cost, choice and performance it could be the blueprint for default funds - or at least that is a popular train of thought.

Not everyone agrees that Nest will unearth the holy grail of defaults. Some consultants believe Nest, with its low charges, will have little influence on the wider sector - particularly employer-sponsored schemes, the reason being that its target audience is low to middle earners and those with minimal savings.

Charges should only play a small part in the decisionmaking process - far more important are aspects such as investment performance and service delivery

Dowsey said: “The charges on Nest are a red herring; the target audience for Nest will dictate the default investment option and this is not likely to over-duly influence - and nor should it influence - the default structure and investment options available for an employer-sponsored scheme. The merits of an employer-sponsored scheme over Nest will justify the differences in investment options and, therefore, any difference in price.”

Dowsey also disagrees with Blake that the DC market has gone mad for passive, and instead suggests that there has been an increased appetite for active fund management. One of the reasons being that active managers are reducing their charges - although she admits that passive funds are still the cheapest option.

“The squeeze on DC scheme charges means that actively managed funds are coming down in price significantly,” she said: “I believe that there is far too much emphasis on charges when selecting funds and indeed providers. They are an important aspect of the overall “package” but should only play a small part in the decision-making process - far more important are aspects such as investment performance and service delivery.”

It is a sentiment shared by John Lawson, head of pensions policy at Standard Life. He reckons that price is of secondary importance and that there is no point buying something that doesn’t do what you want it to.

He believes that trustees, employers and investment consultants are beginning to recognise this, having had to face the ire of scheme members as their equity heavy default funds (both active and passive) have fallen in line with market movements.

“Advisers are beginning to recognise that active management, or actively overlayed protection that does what the scheme members want - rather than what clever people theorise will produce the best returns - has to be paid for,” says Lawson. “That said, price will always have an influence on buying decisions, but it would be possible to move that price to somewhere other than the fund management charge, if price remains an issue.”

Financial advisers say that one difficulty with GPPs (compared to occupational DCs, which often have much lower charges) is that the passive funds tend to have the same annual management charge as the managed fund.

Lee Smythe at Killik & Co, says: “Members do not see any of the cost saving normally associated with using passive funds - presumably extra profit for the insurers.

“Despite not necessarily benefiting from any cost saving for the majority of group scheme members by using a passive range of funds they should get broadly average performance for the sector, rather than running the risk of the managed options significantly underperforming.”

Meanwhile, Andrew Merricks at Skerritt Consultants questions whether advisers that offer the “charges over performance” argument for sticking with passive, simply do not have faith in their ability to get it right.

He says: “If you can demonstrate that you can regularly outperform a benchmark through actively tweaking the constituents of a given risk-rated portfolio then all credit to you, and your actively managed fees become more than reasonable.”

Merricks’ argument is particularly pertinent with larger firms of advisers that offer research and rated funds of their own. Not surprisingly, Hargreaves Lansdown also suggests that focusing on costs is misguided.

Khalaf said: “Focusing on costs to the exclusion of all else is misguided. Yes, cost is important, but at the end of the day a fund which costs 1.5 per cent a year but returns 10 per cent will reward you more than a fund which cost 0.5 per cent but returns 5 per cent.”

It is a moot point, but it is finding that fund that’s the difficult part, and then it has to be monitored. Considering that a pension is a long-term commitment of more than 20 years you can see why many advisers do not have the inclination to stay active, in both senses of the word.

Indeed, some advisers would argue that it is not charges, active or passive that is the issue - it is getting the asset allocation right. But that is another debate entirely.

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