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Blood on the trackers

Five years ago, pension tracker funds were only just coming on to employee
benefit consultants’ radar screens. Now, the two biggest trackers dwarf
their actively managed competitors.
The BGI and Legal & General tracker funds are each bigger than the 10
biggest pooled pension funds on the Caps survey added together.
Moreover, indexation has become an assumed part of segregated pension
funds. More than half the UK’ segregated pension funds have at least one
component of their fund in an index fund, whether it is UK equities,
long-dated gilts or emerging markets.
It is perhaps not very hard to see why this has happened. The large
balanced global mandate has become very unpopular, with none of the big
actuarial or employee benefit consultants favouring the approach of having
one large global balanced manager.
A quick look at the Caps league tables for 1999 reveals why. The usual
suspects are firmly rooted for the most part in the bottom quartile, with
Phillips & Drew in penultimate place over one year in the mixed with
property sector, while Schroder, Mercury and Britannic are in the third
quartile. Prudential is to be found in the fourth quartile.
The biggest fund in the sector, at over £6bn, run by Scottish Equitable,
came 61st out of 67 funds. Clearly, the bigger pooled fund managers were a
disappointment to investors during 1999, when the major gatherers of new
business were tracker funds. Nor was this trend something new, as revealed
by a look at the Caps three- and five-year tables, in which most of the
above reside in the third or fourth quartiles.
Much of the blame can be attached to the UK equity portion of these funds.
Less than half the UK equity-only pooled funds in the survey beat the 24.4
per cent return of the FTSE All-Share index in 1999. In 1998, a meagre 21
out of 81 funds achieved this target, with a similar story in 1997, when
only 27 of 81 funds provided returns above the index.
No small wonder that indexation of UK equities has been the fastest
growing trend among pension funds. Yet, in 1999, there was such diverse
performance between different sectors of the market, with technology, media
and telecoms, energy, metals and mining outperforming strongly, while
engineering, retail and food producers underperformed. There was
consequently huge scope for an active manager to outperform the UK equity
Part of the problem lies in what we mean by active management. Very few
managers in the Caps survey can claim to be truly active by asset
allocation. At the end of 1999, the weighted average fund had 55.1 per cent
in UK equities, with 57 out of 67 funds holding between 50 and 60 per cent
in UK equities.
A similar picture emerges in weightings of international equities, with 62
out of 67 funds within 5 per cent of the weighted average.
The fact is that many so-called active managers are not genuinely active
but, in fact, closet indexers hugging the benchmark of the median fund.
Many of these “active” managers are also hugging indices in their US,
Japanese and European holdings.
A look at the 1999 performance tables from Caps and Micropal reveals a
small number of truly active funds at the top of the leaderboard
substantially outperforming both the indices and the median fund. The
common factor uniting these funds is their philosophy of genuinely active
management, aiming to add value through asset allocation and stock
The key to outperforming at a stock selection level is running a focused,
concentrated portfolio rather than the 250-350 stocks which comprise the
typical portfolio of an “active” manager. Such diverse funds as these can
at best simply replicate the index at a higher price than a genuine index
Therefore, we need to redefine what we mean by an active manager to
separate out from the herd those managers who are really aiming to add
value at both an asset allocation and a stock selection level. Only then
can we find a real revival of active managers.
The Caps survey had the widest dispersion of returns from the median in
its history in 1999, with the top three funds producing twice the median
return, three-and-a-half times the median and over seven times the median
respectively. The active revival is therefore under way, albeit with a
smaller number of managers than it should it be.
Last year was a better year for active managers than 1998, when the top 10
stocks in the pharmaceutical and banking sectors helped index funds
outperform active managers. The risks of index funds, however, have never
been higher, with vast market capitalisations arising out of mega-mergers.
For example, Vodafone now owns Mannesmann, BP-Amoco contains Atlantic
Richfield as well as Arco while Glaxo-Wellcome has combined with Smithkline
Beecham to create companies which are or will comprise more than 10 per
cent of the FTSE 100 index.
The top 10 companies in the FTSE 100 actually account for more than 40 per
cent of the benchmark’ entire market capitalisation.
Tracker funds are also unique in that every purchase of a FTSE 100 tracker
benefits every other tracker fund equally. This is obviously unlike
discretionary funds where an investment in one active fund manager will go
into stocks that are not necessarily a significant part of any other active
fund manager’ holdings.
Costs are a frequently argued benefit in favour of index funds and, where
the returns of an active manager are closely tracking indices, then an
index fund is likely to beat a closet indexer over time, simply by virtue
of lower charges.
A truly active manager, however, who has scope to take a different view to
the index, will have his higher charges easily absorbed by the
substantially higher returns he should be able to generate by superior
stock selection and asset allocation.
A genuinely active manager has nothing to fear from tracker funds. In the
US, where indexation in institutional pension funds is more than 30 per
cent of the value of funds, there is a huge demand for specialist or
satellite active managers who can outperform in their chosen areas of
excellence. The future looks bright for the truly active manager in the UK.


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