PEPS: The Final Countdown: Trackers: are they all treats?

Active funds should not be discounted. By Guy Dennis

As tracker funds have launched increasingly aggressive marketing campaigns, one question has come to dominate the debate about the advantages of tracker funds and active funds: which is superior?

It is not hard to see why marketing executives working for tracker funds are keen to focus on this issue. Faced with the prospect of a head-to- head race, many active funds appear as unhealthy competitors.

Tracker funds boast impressive performance, and when charges are taken into account they look even more attractive. But while comparisons have important implications for investors, they can also mislead them.

As Jason Hollands, director of BESt Investment, points out: "This debate has become a bit stale because people have taken very entrenched positions on it. The fact is that both types of management have a role in any balanced portfolio."

Certainly tracker funds have very important attractions, as millions of investors have recognised by pouring in their money. By far the two largest tracker funds are those tracking the FTSE All-Share Index run by Virgin Direct, with pounds 1.4bn, and Legal and General, with pounds 1.2bn.

As these funds have swollen, active fund managers have been losing business. Many spectators will view this development as unsurprising.

Research by HSBC, which manages active and passive funds, shows that over the last five years 70 per cent of active managed funds, excluding specialist funds, have failed to match the performance of the FTSE All- Share Index. And in the USA, even fewer active funds match the index.

At the same time, research shows that charges tend to be substantially lower for trackers. And they can make a major difference to the value of your investment. In the face of these findings, active managers have a tough job defending their role.

To truly outperform a tracker fund, a fund manager not only has to outperform the index being tracked, which is a major challenge in itself, but to do so by a sufficient margin to offset the higher charges of active funds.

And as well as historical evidence, there are theoretical reasons why his or her chances of success are low, at least in certain markets.

Stock market theorists have always pointed out that if markets are efficient, and all buyers and sellers have access to the same information, it will be impossible to consistently outperform the index.

Active fund managers will not be able to find shares they know are being sold for less than they should be if all buyers and sellers have access to the same information. Which may explain why trackers have done so well in the UK and the USA where markets are very efficient and well informed.

Mr Hollands points out: "Where a tracker is very useful is for blue-chip exposure. The reason is that for the FTSE 100, there's so much information published on its companies that it's very hard for an active manager to add a huge amount of value there."

Unsurprisingly, many UK investors now choose tracker funds as a core holding in their investment portfolio. However, when investment portfolios are considered more generally, the limitations of tracker funds become more apparent.

Most importantly, there is a danger that investors may be tempted to put all of their money into one tracker fund. This means their investment is not diversified and is very susceptible to changes in one stock market.

Amanda Davidson, of financial advisers Holden Meehan, says: "I advise anybody who has all of their money in one fund that they need to start looking at spreading their risk. If all their money is in a UK tracker, they ought to be looking at other areas such as Europe and a general international spread as well."

And Europe is one area where trackers have been less impressive. HSBC's research shows that, over the last five years, half of active funds have outperformed their index for Europe.

Japan is another area where active funds have outperformed trackers. Although returns have generally been poor there recently, as the country has faced economic problems, active funds have suffered less than trackers.

In the last five years, over three quarters of active funds have been able to outperform the index in Japan, often because they have not been forced to buy shares in banks with bad loans.

Alan Gadd, managing director of HSBC Investment Funds Europe, says: "The UK and the US are the two most mature markets and most efficient markets, and the numbers suggest that it is particularly difficult to outperform the index there.

"But generally in Europe, you are better off with an active fund. And when you move further away, and you are going into places such as Japan, Asia and the emerging markets, you're better off with an active fund."

Yet even in the UK there are areas where fund managers can make a substantial difference. Mr Hollands says: "Where active managers can add a lot of value is in multi-cap funds or mid-cap funds or smaller company funds." In these areas research by fund managers is more likely to yield important results.

In the last few years many active fund managers have succeeded in outperforming the mid-cap FTSE 250 index, the index of the next 250 largest companies after the FTSE 100. Unfortunately the sector as a whole has shown poor performance, but the role of fund managers appears more important here.

And especially so at present: many fund managers think that there is now more potential for growth in the small-cap and mid-cap sectors than in the FTSE 100, which has rocketed in the last few years.

Richard Royds, managing director of Mercury unit trusts, says: "This year the phenomena we have seen suggest that trackers aren't going to have a great time because we've seen all the running in mid-caps and small- caps."

At the same time there have been concerns that people investing in FTSE 100 trackers may be concentrating their investment in a very small number of shares, putting themselves at risk.

Whichever type of fund is "superior" - whatever that means - it is clear that managed funds still have their attractions. And although the popularity of trackers may have put them in the shade, it may also do some good for the reputation of fund managers in the long run.

Alan Gadd says: "I think people probably underestimated the positive effect of trackers in the sense that I think that a number of active fund managers had become quite complacent. I think it has led to quite a rethink in certain quarters, which I think will be positive. You need these events to trigger that sort of rethink."