Secrets Of Success: Easy money, for the index managers

The past few years have not been particular easy ones for index funds. Since 2000, small cap and value stocks have dominated performance tables. In combination, this style shift is particularly unfavourable to index funds, which, by their nature, are dominated by the larger companies that are the most important components of the main market indices.

Most actively managed funds, by contrast, prefer to look for bargains among the mid-cap and smaller company areas of the market. When small cap does well as a class, it follows that actively managed funds tend to do better on average, although this effect evens itself out over the longer term.

Throw in the fact that index funds in the UK are far too expensive on average for what they deliver and it becomes clearer why investors in UK index funds have had a relatively disappointing time of it since the market peak in 2000. The five and 10-year performance figures for the period to the end of June this year clearly illustrate the fact.

The figures, says Fund Expert, show that the best performing UK index fund has returned 28 per cent during the past five years and 117 per cent during 10 years. This compares with the return of 50 per cent and 200 per cent plus that you would have gained if you had picked one of the top 20 actively managed funds in the UK equity sectors (All Companies and Equity Income, in the IMA classification).

Put that way, you might say that you could have doubled your money by opting for one of the best actively managed funds - a fair and reasonable reward given that picking the best performing funds in advance is not easy. Even in this unusually unfavourable period, the best index funds still managed to beat around half the funds in the All Company and Equity Income sectors, and more if you include comparable funds from the Active Managed sector as well.

But I cannot reiterate too often that the figures do underline how important it is to pick the lowest cost index fund. The difference in performance between the best and worst UK tracker funds over five years was 13 per cent (the best 28 per cent, the worst 15 per cent). Over 10 years, the differential was more than 30 per cent (a range of 74 per cent to 117 per cent). The FTSE All-Share index returned 27.7 per cent and 114 per cent during the same periods.

Only the best index fundsdo what they promise, which is to match the performance of the market over time. The worst simply transfer between a third and a half of the market returns that you could have gained from owning the cheapest fund into the pockets of the fund management company. This is something akin to highway robbery, since their costs are negligible, and they do virtually nothing to earn the money, merely taking advantage of investors' ignorance.

Almost all the differential in index fund performance is directly attributable to charges, which compound over a period of years just as certainly as investment returns. It is no accident that the best performing index funds over five years (F&C) and 10 years (Fidelity) both have among the lowest total expense ratios of all index funds.

If you want to check out the costs of different index funds, the FSA's oft-derided comparative tables, available on its website, is a good starting place. Or try looking at the Lipper ratings for cost on Reuters' website.

What this means, on the positive side, is that you can be confident that the cheapest index funds from the best providers will be the best ones and give you, over time, the certainty of achieving something very close to the market return. In turn, that means that it is legitimate to take the lowest cost index fund, rather than the average index fund, as your effective benchmark when deciding whether to risk trying to find an actively managed alternative.

Assuming that you are smart enough to buy only the cheapest index fund, the question then is whether you can realistically pick one of the top 20 funds and aspire to double your money (or more). As there are some 500 competing funds to pick from, the odds of you doing so, other things being equal, are about 1 in 25. According to conventional statistical analysis, the top 20 funds are always at least 20 per cent more volatile than the index, so there is a price to pay in risk for even trying. But the much bigger risk is that you don't know how to find the funds that will do best in the future.

One consolation is that a small number of the same names do tend to pop up in the list of five and 10-year outperformers every time, to an extent that cannot be explained solely by their investment style. Three examples would be Anthony Bolton at Fidelity, Neil Woodford at Invesco Perpetual and Andrew Green at GAM.

Many actively managed funds do not give themselves a chance of figuring in the top 10 to 20 per cent of funds, as they are not prepared (or allowed) to risk underperforming during shorter periods of time, which all the best managers will do at one time or another.

Unlike picking stocks, experience suggests that you cannot find the best active fund managers simply by looking at their performance record. Statistical analysis alone cannot tell you which fund will do best in the future: there is too much random information and defects in the figures. Past performance figures, provided they are consistent and go back a long enough way, do have some value in defining the style and performance potential of individual fund managers and teams but that is as far as it goes.

John Chatfeild-Roberts, head of the multi-manager team at Jupiter Asset Management, points out in his book, Fundology, that the only certain path to success is to form a considered judgement about the skill, character and temperament of the individuals who run actively managed funds and back those whose style matches your own objectives. This is something that it is hard for individual investors to do effectively. That is why they are often forced to rely on professional intermediaries, although this brings other potential hazards, such as commission bias, conflicts of interest and additional layers of fees.

The best argument for index funds remains that you can easily pick them yourself, the criteria are straightforward and you can be confident that they will reliably give you second quartile performance over longer time periods. They will never be the best funds you can own but the best ones may be the least worst for your level of knowledge and risk tolerance. As such, they still have a place as valuable building blocks in any portfolio.