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Trackers lose the ascent

Tracker funds were never meant to be “all singing and all dancing” and were never seriously expected to outperform actively managed funds for long.

A recent Money Marketing survey found that the top 10 Isa contracts, using projected growth rates and deducting management charges, were all tracker funds. This comes as no surprise really. Using projected growth rates, the cheapest funds will obviously come out on top.

Of course, active managers have never disputed the fact that tracker funds are cheaper – the point they have always tried to make is that you get what you pay for.

Having an active manager to adjust a fund to make the most of market conditions certainly seems to make sense. After all, there are usually more companies in an index falling in price than rising. The problem for active managers in recent years has been finding the proof to support this self-evident fact.

According to a study by the WM Company at the end of 1998, only a quarter of UK equity fund managers at the time would have beaten the FTSE over five years. Around the same time, it was also argued by commentators that the pressure on active fund managers to outperform meant they had to take greater risks.

Things could have looked better for active managers at the time – they then had charges, performance and risk against them – but two global economic themes conspired to end the tracker furore almost as quickly as it had started.

Two years ago, when active managers seemed at their lowest ebb, the FTSE was being led by what were then considered the stalwarts of the UK market, banks and high-street retailers. With such consistent performance from these powerhouses, it was difficult for active managers to find the elbow room to add value. But then the market turned.

Mega-mergers became a key theme. For example, the newly merged Vodafone-Mannesmann immediately became the biggest company in the FTSE 100, accounting for around 14 per cent of the index. At the time, BP Amoco also accounted for about 9 per cent of the FTSE, meaning that close to a quarter of the index was taken up by just two companies. Suddenly, the risk pendulum swung back toward active management.

Passive fund managers started to have difficulty in holding such large positions as unit trust regulations specifically prevented them from holding more than 10 per cent in one share on risk grounds.

The FTSE has tried to compensate by introducing a new capped index that prevents any share from occupying more than a 10 per cent weighting. But while this development is to be welcomed, it offers relatively little to those investors who were attracted to trackers for their promise of low risk and a broad spread of holdings.

The other fundamental that has had an impact on the prospects of trackers has been the emergence of the telecoms, media and technology sector. Although already a fading memory, six months ago, anything with a dot and a com after its name was a must-have investment while telecom companies continued to shoot the lights out.

While the performance of some of these stocks was nothing short of phenomenal, they introduced a new element of volatility to the UK market which gave active managers all the elbow room they needed.

Active managers had previously maintained a lead in more esoteric markets such as Europe and the Far East but now similar market conditions had arrived in the UK.

The great appeal of trackers – their low-cost passive approach – became their greatest weakness. As TMT valuations shot up and down, trac kers could do nothing except follow the index, helping to exaggerate some of the market&#39s worst excesses.

This was illustrated by the arrival in March of 10 new stocks in the FTSE 100, seven of which were TMT stocks,. Tracker funds were forced to buy heavy weightings in the new stocks – although they were obviously at their most costly – while selling off numerous old-economy stocks such as Hanson, Whitbread and PowerGen. This brought the index&#39s TMT weighting to 38 per cent.

Three months later and four of the new TMT stocks, Baltimore, Kingston Communications, Psion and Thus, were bounced from the index after extensive price corrections. Trackers naturally had to sell them off too, taking a major hit in the process. After the dust had settled, TMTs accounted for just 30 per cent of the index.

Active managers, meanwhile, were busily trading in and out of stocks and generating far superior returns for their investors.

During the year to July 1, the FTSE 100 moved up by only 2.1 per cent, while the FT 30 actually fell almost 6 per cent. This compared with a 9 per cent return from the average UK all companies fund.

The enormous impact of the TMT boom is demonst rated by the fact that recent industry studies report a rising number of funds in the UK all companies, UK growth, and Europe sectors that have outperformed their indices, while almost three-quarters of US funds have beaten the index.

But what of the £12.66bn of retail funds still invested in tracker funds? The simple answer is that, so long as investors do not expect their trackers to outperform the average active fund and understand the real risks of a passive portfolio, they are still getting a good deal for their money.

In a diminishing interest-rate environment, trackers have a lot to offer. Stockmarkets, as we know, always outperform deposits while a tracker fund&#39s low charges mean that getting access to your funds can also be cheaper.

Add to this the opportunity for low-cost global diversification within a private portfolio and it is clear that trackers still have an important role to play. Ultimately, though, that role is as a member of the supporting cast in a portfolio. Investors must look to active managers to take the lead.

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