The tracker fund debate continues - and the `closet tracker' is outed

IN THE past three to four years, a long-running debate has simmered on in the financial world over the respective merits of "tracker" versus "actively managed" funds.

Trackers, which simply replicate the performance of the FTSE 100 share index or the slightly broader FT All Share index, have had a whale of a time. In the past few years, they have consistently outperformed against most other funds in their sectors.

What is more, because they are far cheaper, with no initial charges and annual management fees of 1 per cent or less, investors keep more of their money. Small wonder then, that trackers have soared in popularity, attracting many billions of pounds from first-time investors.

Active fund managers have been caught in a vice. They might claim that there is a danger of major price distortions because shares rise not in relation to their underlying value but because of huge inflows of cash into them.

But it is difficult for them to argue the line, day after day, while the value of FTSE 100 company share prices continue to rise, while their own bargain-hunting yields meagre results.

So what does an active fund manager do? Well, according to Money Marketing, a specialist magazine, he or she becomes a "closet tracker", buying shares in leading Footsie companies almost in the same proportion as trackers themselves.

So, for instance, the top 10 Footsie stocks as at 1 March were BP Amoco, Glaxo Wellcome, British Telecom, Lloyds TSB, HSBC Holdings, Smithline Beecham, Vodafone, Shell, Barclays and Diageo.

Taking three funds as an example - Fidelity's UK Growth, Hill Samuel British Unit Trust and Henderson UK Capital Growth funds - all hold the shares of between seven and 10 top 10 Footsie companies, in roughly the same proportions as their weighting in the index.

I have no problems with this "convergence" strategy. If active fund managers want to stay within spitting distance of trackers when the Footsie is the key determinant of market performance, they must invest in the same shares - and on the basis of similar weightings.

Where I do have a problem is with charges. Hill Samuel, for example, levies a 3 per cent initial charge and a 1.5 annual management fee on a fund which basically mimics the Footsie top 10. Fidelity charges 3.25 per cent, plus a 1.5 per cent annual management charge on its unit trust range. Henderson's unit trust initial charges are 5.25 per cent on initial contributions, plus annual fees of between 1 and 1.5 per cent.

Compare that with no initial charge for most trackers and management fees of between 0.5 per cent (lower in a handful of cases) and 1 per cent. As most fund managers will privately admit, the chances of a managed fund out-performing a tracker by 1 per cent or more a year for 10, 15, 20 years is highly unlikely. If so, why should investors pay for something they are not getting?

For many months now, fund managers have told us that their superior skills mean they can't possibly meet the Government's CATmark standard on charges, which calls for annual fees of not more than 1 per cent. Now that we know so many of them are little more than closet trackers, I look forward to seeing them cutting their charges as a result.