Investors are flooding into ‘passive’ tracker funds, but cut-price charges are blinding the punters to a fatal flaw in their performance

While many doubt whether City stock-pickers really add value, professional fund management can pay dividends in the long run

A nasty power struggle in the Square Mile and dismal investment returns make this a good time to ask the question: is it worth paying for professional fund management?

Most investors seem to have decided the answer is no. Just look at the figures showing that tracker funds, which passively follow a stock market index rather than charge for active share selection, account for three-quarters of new sales. The Investment Association’s most recent monthly figures show net retail inflows of £690m, of which £527m — or 76% — went into tracker, or “passive”, funds.

After 15 years in which the FTSE 100 index of Britain’s biggest shares has made no progress — remarkably, it still trades below the 6,930 it closed at on December 30, 1999 — the explanation would appear to be that many investors doubt whether City stock-pickers really add value.

Worse still, at about 1.5%, the fees for actively managed funds are more than twice as high as the typical costs of passive unit trusts and exchange-traded funds.

Nobody seemed to care much about annual management charges during the great bull run of the 1990s, when many equity investors enjoyed double-digit gains. Yet now the annual costs of actively managed funds often absorb nearly a quarter of average gross returns — which have sunk to 7% over the long term, and rather less recently.

Rising investor cynicism and falling fees have sparked an existential struggle high up in the plate-glass palaces of the Square Mile. For example, I was sad to see Daniel Godfrey, chief executive of the Investment Association, defenestrated after he urged fund managers to be more open about costs and to put their clients first. He is a good man who did not deserve to be ousted from his post.

Rather than getting bogged down in the rights and wrongs of a trade dispute, I asked some financial advisers and intermediaries to scrutinise returns since the turn of the century to see if active fund management beat passive index-tracking. …….

……  Perhaps surprisingly, their calculations show that £10,000 invested in the average UK equity income unit trust would have grown to £24,500 since the turn of the century, compared with just £16,300 in the average UK tracker fund. Both figures include charges and reinvested income (dividends).   ……

……  I invest about 80% of my “forever fund” directly in shares to keep costs down and yields up — sometimes with horrible shocks, such as Volkswagen, discussed here last month. But the rest of the money is in funds, particularly smaller companies funds with managers who seem likely to add value. They can scrutinise corporate acorns many of us have never heard of before they become the oaks of tomorrow.   ……

……  Alan Steel, who will celebrate 40 years as an independent financial adviser next week, pointed out a fundamental problem with passive funds: “The best way to create investment profits is to buy low and sell high, but tracker funds do the exact opposite. They are overexposed to shares trading above their fair value and underexposed to shares trading below their fair value. The more a share rises, the more tracker funds have to buy, and vice versa.”

So, as in many walks of life, the cheapest option is not necessarily the best value. Cost should not be our only criterion in matters of importance — as I hope readers of this newspaper will agree. That’s why, despite soaring sales of trackers, I continue to believe it can pay to stump up for professional fund management and shrewd stock selection.

Quote courtesy of The SundayTtimes
Sunday 18 October 2015