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Perfect balance

Indexation became increasingly popular during the late 1990s as investors became disenchanted with paying relatively high fees to active managers who failed to beat market returns. Last year saw a reversal in the fortunes of active managers. What does this mean for indexation?

While active management offers greater opportunity, indexation still has a role to play in investors&#39 portfolios.

Investors in index funds are often warned that such funds track the market down as well as up. This was demonstrated last year when, in most major markets, index funds underperformed active funds. In the UK, the average UK all companies fund beat the average UK retail index fund by around 2 per cent in 2000.

But this followed two years when active managers generally failed to get close to index returns. So, where does this leave the active/passive debate? Arguably, unchanged, since the past few years have served only to demonstrate that the debate about which investment style is “better” is a facile one. The question of how best the styles can be combined is one much more worthy of consideration.

That each of the two styles has a role to play in investors&#39 portfolios can be seen by considering the reasons behind the fortunes of each style in recent years. During 1998/99, a number of circumstances combined to make successful active management much more than before.

First, the narrowing of the market into a small number of very large stocks (the megacap effect) and sectors (the TMT effect) meant that market performance was difficult to capture without a very broad portfolio. Market outperformance generally required taking overweight positions in this narrow range of stocks, a concentration of risk that many managers understandably felt uncomfortable with.

Second, the market lost touch with reality and stock valuations became detached from the underlying fundamentals of the companies concerned. For active managers, who base their views on these fundamentals, life became ever more frustrating as good analysis gave way to hype.

Third, index funds themselves have been criticised for contributing to the unjustified surge in some stock prices as they purchased new index additions at any price in order to maintain their tracking.

This effect was magnified by the fact that although many companies chose to release only a relatively small proportion of total equity to the market, these companies&#39 shares were included in the index as though all of their equity had been made available. Again, fundamentally focused active managers could not justify these prices and missed out in performance terms.

Market conditions were not wholly to blame. Many active managers simply got it wrong and called the end of the bull market too early, moving into defensive stocks which continued to get battered as they were dropped for more fashionable securities. Index managers continued to capture the full market effect of the investing public&#39s obsession with the new economy. Index management, with its “better” performance and lower fees seemed to be the only party in town. And then the music stopped.

The main reasons why active management fared so much better last year are simply the reverse of the reasons why it had such a tough time for the previous two years. Once investors realised that the heady earnings expectations of the new economy were not going to be met or, in some cases, that there would be no earnings at all, the stellar valuations accorded to these stocks began to fall.

Active managers who had missed out on the run-up of these stocks found their performance against the index was flattered by simply not holding these shares.

Defensive stocks – the old economy as they used to be called – finally had their day and many active managers benefited from their overweight holdings here. The broadening of the market to something closer to normality than we have had for some time has enabled active managers more easily to add value within acceptable risk constraints.

Finally, in a reversal of the technical effect highlighted earlier, tracker funds became forced sellers of unpopular TMT stocks that were dropped from the market index. This further depressed their performance relative to their active peers.

Active managers clearly have lessons to learn from the past few years. There is a much greater awareness of the effect index changes can have on a stock&#39s valuation, although FTSE has recently amended its rules to avoid a repetition of some of the technical squeezes of recent years.

Risk management techniques have become a lot more sophisticated, allowing managers to see exactly what views they are taking, both in holding the stocks in which they are invested and, often more important, in not holding stocks in which they are not invested.

Many fundamental analysts are looking at additional methods to help them understand a stock&#39s value better. For example, many traditional valuation techniques are earnings-based and so are less appropriate for valuing new, high-growth companies where earnings are often non-existent. Looking instead at projected cashflows is one way round this problem.

The past few years have demonstrated how passive funds benefited during abnormal market conditions. But does the return to relative “normality” now mean that passive is dead? Not at all. The late 1990s were abnormal compared with previous experience but there is no doubt that the market conditions seen then could return.

You cannot assume that index funds would be as successful relative to their active counterparts as they were last time, but it seems likely. A balance between passive and active is likely to be the most efficient portfolio for many investors in the future.

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