Passive aggressive

Three big outfits - BGI, L&G and State Street - dominate the index-tracking arena in the UK. Now they have a rival in the shape of US giant Vanguard. The tracker pioneer has just launched its first tracker funds aimed at British retail investors and is expected to be targeting workplace pensions later down the line.

Whatever your focus, its arrival has stirred the debate over which style of fund management is best: active or passive?

That debate, over which style produces better returns for investors over the long term, has carried on since index-based funds appeared in the mid-Seventies. Money managers focus primarily on one approach or the other. Active managers look for companies they expect to beat the market. Passive investors try to track benchmarks such as the FTSE100. Study after study has failed to provide a conclusive answer.

But it is no longer about which is best; it is about how best they can work together. Larry Fink, chief executive at BlackRock, the company that has just acquired BGI to create the world’s biggest fund manager, says: “In the retail space, passive strategies are going to take up more momentum. But I do believe that active strategies are just as important in the future.”

Burton Malkiel, author of A Random Walk Down Wall Street, which examines efficient-markets theory, says: “It’s not active versus passive anymore, it’s active and passive. Even people who believe strongly in active management realise there’s an advantage to a mixed strategy that includes index funds at the core.

Though it is early days, Vanguard’s arrival is notable. This is an American giant that launched the first tracker mutual fund in America in 1976. Today, the group has assets under management of £760bn and its entry into the British market is a signal of an impending war of the prices investors pay for funds.

Vanguard is one of the dominant players in the US pensions market and it hopes to leverage off that experience to make headway in Britain and wrestle away the stranglehold of BGI and L&G in the passive arena.

It is already meeting with fund platforms for the GPP market and has met with trustee-led schemes too.

Cost is one of Vanguard’s sales pitches. It says that the cost of funds is a drag on performance and it will undercut its British rivals with funds having a total expense ratio of just 0.15pc. Most active funds in Britain have an annual total expense ration of more than 1.5pc.

Tom Rampulla, managing director of Vanguard UK, says: “It is not about active versus passive. The key is to keep costs down and it is a message we are keen and committed to getting across to UK investors.”

Rampulla admits that the British employee is less engaged than US workers who have had to grapple with 401k plans. He admits that education will play an important part in Vanguard grabbing market share from the big three.

When Vanguard introduced the first tracker mutual fund designed for individual investors in 1976, active money managers were critical of the value they could add.

Rampulla says: “If you settle for matching the market instead of outperforming it, you’re conceding defeat.” Yet, despite the naysayers, it is difficult to argue with performance figures. Today, the Vanguard Total Stock Market Index Fund and Vanguard 500 Index Fund are among the largest equity mutual funds in the world, with more than £51bn and £44bn in assets, respectively.

Using the Morningstar Direct database of equity mutual funds, Vanguard compared actively managed funds with the MSCI Europe Index during six periods with stock market declines of greater than -10pc.

It found that the majority of active funds failed to beat the index in three of the six European bear markets. The results indicate a lack of consistency with respect to the performance of active funds in general. “No fund successfully outperformed the market in all six bear markets. Because there is no guarantee that a winner in one bear market will outperform again, selecting the next winning fund is like finding the proverbial needle in a haystack,” adds Rampulla.

Nobody doubts that the best active funds will outpace tracker funds, but it is the downside limitations in that they will never be fourth quartile performers that make them a perfect foil for default funds. It takes away the blame should a poor choice of active fund deliver woeful returns.

But there are still plenty of passive doubters. “It is often argued that because the average active fund manager fails to beat the market it’s pointless attempting to find one that will. I don’t buy that. It’s like Sir Alex Ferguson saying that because most people can’t hit a barn door from 20 yards with a football he won’t bother trying to grow or buy the best team he can,” said Tom Stevenson, an investment commentator for Fidelity International.

He adds: “The odds in investment are anyway rather better than for a football manager – recent analysis of the UK pension fund industry showed that in all but one category [Japanese equities] the top quarter of managers beat the market over the past three years. Given that there is more to stock-picking than just luck, I’d fancy my chances of spotting the one in four that will go on to justify his fee.”

But Chris McWilliam, a consultant at Aon Consulting, says that its house view has remained unchanged. “We like passive and think it is the most appropriate strategy for default funds because there is little risk of sustained underperformance and they often outperform in terms of sector averages.

“Lower charges can also make a difference and active managers not only have to outperform, they have to do so by outperforming the difference of the charging gap.”

McWilliam says that he has seen no significant shift in attitude from trustees either, despite the market falls and so long as the tracking error is minimal any tracker fund from the big three is OK. “Trustees realise it is a long-term game and that markets go up over time and trackers are well-placed to benefit from that. However, BGI is on our watch list given its recent takeover by BlackRock and we are keeping a close eye on developments to ensure that nothing has changed.”

That said, the method used to track an index could also affect returns. Trackers fall into two main camps – those that fully replicate the index and those that use different sampling techniques.

Trackers that fully replicate the index such as Vanguard, buy and sell when stocks enter and leave indices. A tracker that samples, on the other hand, may exactly replicate only the big stocks in each sector, be it banking, pharmaceuticals or telecoms. It will then take a sample of the remaining stocks in each sector, holding a little bit more of one and less of another. However, the actual weighting of each sector in the tracker fund will be the same as its weighting in the index it is following.

Legal & General uses a sampling approach, which means it will not hold the exact amount of a stock needed to replicate the index all the time. This often occurs when a stock is about to be promoted to the main index, as forced buyers can cause price anomalies.

Active fund manager fan Mark Dampier at Hargreaves Lansdown agrees investors could use both passive and active funds, as each has their own merits. “I am not averse to tracking the S&P 500 because, given the efficiency of US markets, it is very hard to find an active manager that can consistently outperform it.

“However, areas such as the Far East, emerging markets and small caps are less efficient because there is less available information and more market anomalies.”

Mick Gilligan at Killik & Co readily admits that he is not a great fan of trackers, although he is not averse to using exchange-traded funds, which also track stock markets.

“We believe that in the current market conditions active management is better placed than passive management over any reasonable time frame. The evaporation in liquidity means that a number of mid-sized and smaller stocks are trading at valuations that reflect their tradable volume but belie their ability to generate future earnings. These stocks will be de-emphasised in a passive approach whereas an active manager can overweight them. We think this will be a fertile hunting ground for active managers over the next few years.

“That is not to say we do not see a place for passive investing. We do. Indeed our use of ETFs has increased significantly in recent years. However we view equity ETFs as a means of getting quick exposure to the market or of parking money when we have a positive view on equities but want time to finesse our thinking on which funds or stocks to buy and in what proportion.”

The popular split for pension funds using passive strategies is a 60:40 split. Take the BGI Global Equity Index (60/40). Basically it has 59 per cent in UK equity index, 13.2 per cent in European equity index, 13.2 per cent in US index, 7 per cent in Pacific Rim and 6.7 per cent in Japanese equities.

Tony Filbin, head of workplace pensions at L&G, says: “A 50:50 strategy used to be popular but I would say that our 60:40 fund is the norm now. Target-date strategies are being looked at where assets shift as they near a target retirement date but it is early days for this recent innovation.”

The inflexibility of traditional index funds is something a new kid on the corporate pension block is hoping to expose as it makes its foray into the corporate pensions space.

Evercore Pan-Asset whose partners include Tory MP, John Redwood, launched last year and already has £100m of pensions assets under its control. It advocates passive investing but instead of using tracker funds, it uses exchange-traded funds.

It believes that taking carefully considered asset allocation decisions is the crucial part of the investment management process. A range of studies over more than 20 years concludes that in most cases more than 100 per cent of investment returns can be attributed to these key decisions, it says.

Christopher Aldous, Evercore chief executive, says: “Identifying the correct assets classes in which to invest is more important than selecting the underlying stocks. Successful asset allocation is the key to good investment performance. Most stock picking is a costly failure – index tracking is much more effective and investment should be approached on a global basis. We are moving from an Atlantic centric world to a more Pacific-centric world.”

Evercore Pan Asset’s universe embraces around 40 asset classes and covers all geographic regions. The asset allocation team analyse each asset class regularly to find the best investment opportunities around the world. To implement these views, the company has developed a distinctive ‘core/satellite’ investment approach using ETFs as the building blocks for portfolios.

Exchange traded funds are not new in the US and they have proved popular in the US for 401K plans. But it might not be long before workplace pensions adopt ETFs as a matter of course in the UK. Standard Life is one outfit that is said to be considering including ETFs on GPP platforms as an alternative to the traditional tracker funds.

John Lawson, head of pension policy at Standard Life, admits it is on its radar. “It is possible for ETFs to go into a group Sipp and it is something that is under review. If a consultant or a scheme came to us wanting an ETF option it is something we would look at,” he says.

There is little doubt that passive funds will have been buoyed by the market falls over the past two years – it has been a time when even the best fund managers have come unstuck. Trackers remain the funds of choice at the moment for default funds – an index fund is the default option for BT, the UK’s biggest DC scheme. With personal accounts and rule changes from RDR on the horizon the emphasis on passive funds is likely to be even greater.

“If a fund for personal accounts is charging 50 basis points it is likely to be passive and advisers will have to justify if they offer anything more expensive,” said Lawson. “That is likely to drive the demand for passive investing within pension funds even further forward.”