Personal finance: Why managers are actively copying tracker funds

Active fund managers are fighting back, if only by behaving more like their index fund rivals.

Twice as many active fund managers outperformed the FTSE All-Share index last year as in 1995, according to research from HSBC Asset Management.

HSBC's figures have loaded the dice in favour of active managers by ignoring the entry charges they impose, expressed as a bid/offer spread. This has a dramatic effect, giving HSBC a figure of 48 per cent of UK equity trusts beating the FTSE All-Share index in 1997.

After charges, Virgin Direct puts the figure at closer to 5 per cent. Even without charges, Fidelity believes the figure is no higher than 16 per cent.

HSBC's managing director, Alan Gadd, argues that ignoring charges allows the figures to concentrate on investment performance alone. But he admits: "On an offer-to-bid basis, it would take a phenomenal performance to beat an index which is already such a tough benchmark."

But it is the trend over time - shown in the graph below - rather than the figures themselves which is most interesting, and here there is more of a consensus. Since about half-way through last year, active fund managers have been buying into the blue-chip stocks contained in index funds, boosting their performance in the process.

Index funds try simply to replicate the performance of a given basket of shares, aiming to eliminate the risk that your fund's manager will simply pick the wrong stocks to buy. Many choose the FTSE 100 index, which consists of Britain's largest companies, as their benchmark. Over the past year or more, these companies have delivered the best growth.

Mr Gadd says: "The last three years has been an exceptional time for the index and trying to outperform it has been tremendously difficult. Active fund managers have realised that being too far away from FTSE 100 stocks was probably working against them. My feeling is that, over the past two or three years, active fund managers have moved closer to the index."

Virgin Direct's marketing manager, Gordon Maw, agrees. He says: "The market's become a bit simpler for active fund managers. Until a couple of years ago, the growth potential was all in small companies, so people were trying to pick small company stocks.

"In the last year or so, there's been a real swing back to larger companies. The active fund manager's job has become enormously easier because of that."

Fidelity's Jo Roddan adds: "There is a trend towards better active fund management. People have generally been improving their stock-picking over the past 10 years. These figures do show that active fund managers are doing better."

Mr Gadd does not question the long-term value of index funds - even his own company's figures say only 18 per cent of active funds will beat the index over a 10-year term. But he does fear that the bull market of recent years may have convinced some investors that indexation is a panacea to all their woes.

Mr Gadd says: "Our concern is that people are starting to see indexation as a quasi-guarantee. For the past few years, it has been, because the market's gone up. But I don't think people should be lulled into thinking indexation is some kind of capital protection. The worst thing about indexation is, not only do you hold all the good stocks, you hold all the bad ones."

He believes we may be in for a period where medium capitalisation stocks once again outperform their bigger rivals. "We see that as quite an interesting area at the moment," Mr Gadd says. If he is right, that could hit the index funds trapped within the narrow range of the FTSE 100.

Mr Maw, whose own index fund shadows the broader FTSE 350, says: "The bigger companies are looking good at the moment, and they're obviously performing well. But the danger with the FTSE 100 is that it's a very narrow band to track. It's purely larger companies and, if they're not performing, then you're really exposed."

Direct Line, Guardian and Lloyds Bank are just some of the companies with trackers based on the FTSE 100.