Passively managed funds, commonly known as trackers, provide broad access to stockmarkets at lower costs than active funds.
They have a role, but only as part of an investor's balanced portfolio. They work best in efficient investment markets with a broad index, such as the UK and the US, and less well in inefficient or fragmented markets, like Japan or the Pacific Basin.
Trackers are, or should be, commodities. Therefore, the key elements that investors should look for when investing in tracker funds are low charges and low tracking errors, to ensure consistent returns.
M&G's research recently found that some FTSE 100 and UK All-Share tracker funds are more inaccurate than others when tracking the index, hence skewing performance rankings.
Furthermore, rankings have no bearing on how the fund has, or will actually perform, year on year.
The findings highlighted the fact that companies ranked in the top five over one year may appear in the bottom five during the following year.
The decision to include trackers in our range of funds in no way detracts from our fundamental belief in, or commitment to, actively managed funds. While trackers provide ready access to the main stockmarket indices, they are inevitably less flexible than active funds and do not cater for investors with particular requirements. For instance, they do not give access to more specialised areas of the market such as:
Income (corporate bonds and equity investments).
Thematic investments, such as growth, special situations.
Global funds such as global financials.
Areas where indices are meaningless, for example, smaller companies, emerging markets.
TMT (technology, media & telecoms) has been the focus of recent investor enthusiasm, which accounted for 35 per cent of the weighting of the FTSE All-Share Index last year. This has an important bearing on the performance of the market.
Index trackers cannot avoid taking action if TMT shares are felt to be overvalued, neither can they compete with dedicated tech funds in periods when TMT is in favour. In short, trackers cannot take a view but actively managed funds can.
At least 20 per cent of total UK funds under management are run on a passive basis and this includes closet trackers. In the US, this figure is 28 per cent.
At some stage, the relentless growth of indexation will undermine the efficiency of the market. If this were to break down, it would have dangerous implications for investors.
A bigger issue is the increasing market concentration on a few stocks. BP Amoco, for example, is around 10 per cent of the FTSE 100 index, while the 10 biggest stocks account for around 50 per cent of its total value.
This increases volatility. Since trackers must match the index, they are fully exposed to this volatility to stock-specific risks. Hence, trackers are not quite as low-risk as passive fund managers suggest.
Over the year to February 2001, 168 of 305 active UK funds beat the index, compared with 11 of 53 trackers. This shows that investors' chances of beating the index are more than doubled, simply by picking an active fund over a tracker fund.
Clearly, the funds which beat the market change year on year. But why pick one year? Investors generally have long-term horizons and over five years, one-third of active funds outperform the market. Nobody said it was easy to choose good active funds but there is no doubt that it is worth the effort.
A sensible investment strategy for investors would be to have a well diversified strategy with exposure to a broad range of assets, including fixed income stocks (bonds), overseas markets and even thematic funds.
The exact balance depends on individual circumstances, such as the level of acceptable risk.
Trackers could form part of this mix but well managed active funds are ideally placed to seek out undervalued anomalies and special situations in the market, which trackers are not.
We are not saying that passives are bad, just that actives can be good.