Sometimes it pays to be passive

PEPS are like any other investment: you must know what you want to achieve if you are to make an informed choice. One of the first things to decide is do you mainly want the plan to provide you with an income, or are you looking for capital growth?

PEPs are long-term investments, which generally should be kept for at least five years if you are to reap the full benefits of the stock market. They aim to achieve income or capital growth, sometimes both. Typically, a PEP earns between 3 per cent and 5 per cent a year in dividends as well as achieving capital growth.

PEPs that have an income bias concentrate on buying shares with higher than average dividends - this can be at the expense of capital growth. Those looking primarily for income from a PEP should consider a corporate bond plan or one that explicitly aims to achieve a high income. The yield quoted for a PEP is the best indicator of its investment objectives.

Once you've decided on your requirements, you then have to choose between an actively or passively managed fund. With the former, your plan manager selects which shares to invest in within a specific investment sector. This could be a specialist area, such as small companies, or a particular region such as the UK or continental Europe.

Passively managed funds - more commonly known as trackers - aim to mirror the performance of a particular stock market index - either the FT-SE 100 or the FT-SE All Share. Both these indices are based on market capitalisation - in other words the price of the shares multiplied by the number in issue.

Supporters of the FT-SE 100 as a benchmark point out that it represents almost 70 per cent of the market by value, and that the large companies it covers generally do better in recession than the market as a whole because of their financial strength. Backers of the All Share say it is more representative since it covers 95 per cent of the market by value, and that it benefits from the inclusion of smaller companies, which are more agile and therefore often outperform the leaders.

Funds that track the FT-SE 100 are offered by HSBC, Fidelity, Midland, Sovereign and Virgin Direct, while Equitable Life, Direct Line, Kleinwort Benson, Gartmore, Old Mutual, Morgan Grenfell, Legal & General, HSBC and Norwich Union track the All Share index.

This week, Legal & General is to launch a closed-end PEP which will track the All Share index for the next five years. The Election PEP will have extra features to its standard tracker and, according to Legal & General, "will help calm fears that investors have expressed about potential volatility in the stock market in an election year".

In order to mirror the performance of an index, some tracker funds buy shares in every company included in the index while others use complex computer programs to "sample" the index. Think of this as rather like opinion polls that question a few thousand people whose age and other details match the population as a whole.

Unfortunately, there is not yet enough evidence to say which index or tracking method gives the best performance - although Gartmore has gone on record as saying that buying every share in the index is highly inefficient.

Since the All Share has an annual yield of around 3.7 per cent, once a tracker PEP's annual charges are taken into account, investors can expect an annual income of around 3.5 per cent. The yield is similar with FT- SE 100 trackers.

Because of this, investors looking for a higher income stream from their PEP may find a tracker inappropriate.

In general, tracker funds are among the top performers in their investment sectors. Not only do they regularly come in the upper quartile - the top 25 per cent - in their sectors, but many actively managed funds fail to perform as well as the All Share index each year.

Many investors feel that if the experts fail to do this, a tracker fund is the best option.

As Alan Gadd, managing director at HSBC Asset Management, points out: "Trackers are the simplest way of buying 'the stock market'.

"They are ideal for people who recognise that the stock market is rewarding over the long term but don't want the added complication of making the investment decision that an active fund brings."

Trackers also offer the relative safety of a fund that will reflect the overall growth in the market. Nigel Webb, a senior manager at Equitable Life, says: "For the average investor, trackers are a very safe way of investing in the stock market. You don't get any surprises with a tracker."

But investors looking to do more than keep up with the stock market will need to look at actively managed funds. As Mr Gadd says: "As soon as you want more income or growth, you have to move away from the trackers."

Firms running actively managed funds are looking to add extra value. When the stock market is at an all-time high, as it is at present, blue chip share prices are relatively high. Unlike a tracker fund, an actively managed fund is able to look elsewhere for value.

When the FT index shares do not do as well, the advantages of an actively managed fund can become apparent, says Anthony Yadgaroff, group managing director of the performance analyst Allenbridge PEP Talk.

"Active fund managers will tend to perform better in bear markets. In the last few years, we've had a bull market. Therefore, index trackers have performed well," he says.

Despite this, a number of actively managed PEPs have outperformed the All Share index and tracker PEPs (although the comparison depends on exactly when you compare the performances).

The greater flexibility of actively managed funds over trackers also means that if the manager sees one area of the market is going or currently doing well, this can be exploited.

A tracker, on the other hand, has to stick to its set formula and so could miss out on this potential area of growth.

It should also be remembered that an actively managed fund may have a different risk profile to a tracker. For those prepared to take more risk, the potential gains can be higher, and by the same token the losses greater. To compare a fund with a high-risk profile to a tracker is fruitless as the two have different objectives, and investors expect to have a bumpier ride with the higher-risk fund.

Actively managed funds require more research than tracker funds and so incur higher costs, which are then passed on to the customer. While investors may be prepared to accept higher charges on a successful actively managed fund, it may be that they will want to think again if a tracker consistently outperforms the fund.

Martin Campbell, product development manager at Virgin Direct, says: "Many actively managed funds fail to match the All Share index.

"Despite this, people still are being charged an initial fee of 5 per cent on actively managed funds. What are they paying for when they can track the index for a fraction of the price [and] a more consistent top- class performance?"