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Passive resistance

When it comes to words of investment wisdom, it is always worth paying attention to the musings of the Sage of Omaha, Warren Buffett.

As chief executive of Berk-shire Hathaway, Buffett has proved to be one of the shrewdest investors in the US and his views always make interesting reading.

He says: “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results, after fees and expenses, delivered by the great majority of investment professionals.”

Clearly, Buffett knows a good thing when he sees it. But in the cold climate of today&#39s UK market, doubters of the passive school of investment management are arguing that during a bear market, stockpickers will leave the trackers trailing in their wake.

Sadly, the ability of active fund managers to defy gravity and avoid the pitfalls of a bear market is something of a myth. In practice, it does not work quite like that. Currently, £50bn of investors&#39hard earned money is in active funds that have fallen further than the market.

Yes, a tracker will follow the market down but that is as far as it will go. Only an active fund manager is able to take a 19 per cent market fall and turn that into a 46 per cent fall in the fund. In fact, since September last year, only one fund in the UK all companies sector is currently in the black and, overall, two-thirds of the active funds have fallen further than the index.

There are two very real dangers with active funds in a bear market. The first is that the arrival of a bear market will catch fund managers on the hop and the second is that just as no one can predict the start of the bear market, no one will be able to call the timing of the recovery either.

Professor Simon Keane of the University of Glasgow has analysed stockmarket corrections and in his study, Index Funds in a Bear Market, he concludes: “There is no way of anticipating the phases of a bear market exc-ept by luck or with the advantage of hindsight.

“The notion that active fund managers can systematically anticipate the start or duration of a bear market with sufficient accuracy to give them an advantage over index funds is insupportable.”

The second key point is the assertion that active funds will add value above the benchmark index. The truth is that many active funds do no such thing, either in a bear or bull market. A study earlier this year by investment analysts the WM Company, commissioned by Virgin Direct, revealed that more than 40 per cent of active funds in the UK all companies sector are “closet trackers”.

When the WM Company examined fund performance over the past five years, it discovered that more than 40 per cent of active funds showed a mean deviation from the benchmark index of between 0 per cent and 3 per cent.

The report stated: “It is questionable whether any investor should pay active fees for a manager who does not deviate substantially from benchmark weights.”

The last commonly held myth about tracker funds is that they are now far riskier than they once were because of increased company concentration in the FTSE 100 index.

Once again, a close scrutiny of the issue reveals that nothing could be further from the truth.

Dr Patricia Chelley-Steeley of the University of Stirling examined the risk associated with the increasing size of FTSE 100 firms (see the table on the left). She reported that as firms grew in size, they diversified their businesses and became less risky. The risk associated with indices such as the FTSE 100 and the FTSE All Share has been decreasing by about 2 per cent a year since 1986.

Dr Chelley-Steeley&#39s study also showed that big firms deliver higher returns for less risk than small or medium-sized companies.

So, in conclusion, we are still very much with Warren Buffett on this one. Trackers remain an investment for all seasons and should form the basis for any sensible investor&#39s portfolio.

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