Active v Passive: Where do you stand?

The question of whether paying for active fund management is money well spent sits at the core of the debate of the role of investment advice on pensions. Paul Farrow reports

The active versus passive debate has embroiled fund management circles for decades. Numerous studies have been undertaken on the issue and the results often depend on which side of the fence the sponsor stands.

But the growth of Sipps and expansion of external fund links on group pension schemes means for pension advisers the issue has never been more important. For every study that proclaims that index funds are better than actively managed fund, there is one that argues that actively managed funds deliver greater value.

“A couple of years ago, the general view was that passive funds should form the basic proposition for a DC scheme but that is no longer the case,” says Crispin Lace, senior investment consultant at Watson Wyatt.

Lace says one of the reasons for the popularity of passive funds was governance issues – trustees could not or were reluctant to switch without consent. It has also meant that where active funds were chosen, they were managed by so-called mainstream houses that were deemed safe. But in reality many manage dismal inflexible funds that let investors down.

“The world has evolved and we are now having discussions with active managers. Access has improved,” says Lace. “We believe active works best if you are a focused investment manager with the freedom to do what you are good at and are not constrained by rules and regulations. These managers’ convictions can help add value. Typically, these managers were only available to segregated clients and deemed too risky for DC plans – not any more.”

But despite the assertions of Lace, index funds are still commonplace in the workplace although not in the growing Sipp market.

Earlier this year, more than a third of UK corporate defined contribution plan administrators said they were not confident that their plans would provide employees with an adequate income in retirement, especially when employees choose a default option that provides low risk and low returns.

The SEI study found that many default options are still based on index funds, which “do not allow the opportunity of outperformance available through active management,” according to the survey results. SEI interviewed 100 executives responsible for defined contribution plans with £10m to £500m in assets.

On the other hand, of the top 50 funds sold to James Hay Sipp investors, juts one fund is a tracker. Meanwhile, Hargreaves Lansdown has about £8m in UK tracker funds through its Sipp – representing around 0.5 per cent of its total Sipp assets. The most popular is the HSBC FTSE All Share tracker which has an annual fee of just 0.25 per cent.

Trackers are not without their drawbacks. The critics of tracker funds will argue that trackers offer no added value because they can’t. Charges mean that they will always underperform the index they track. This can add up to a considerable sum over a long period of time.

A glance at the statistics from Morningstar tells the full story. Take the popular Virgin UK Index Tracking fund, which charges 1 per cent a year. Over a decade, the fund has returned 72 per cent, yet the FTSE All-Share index which it purports to mirror has soared 91.6 per cent – almost 20 percentage points higher. The best-performing fund – F&C FTSE All-Share Tracker – has returned 86 per cent.

Over 15 years, the All-Share has climbed 389 per cent compared with the average tracker fund which has risen by 327 per cent. It is the same with FTSE 100 trackers. The blue-chip index has returned 75 per cent over 10 years while the average FTSE 100 tracker has climbed just 56 per cent.

Markets also move in cycles, which can hamper tracker funds. The FTSE 100 makes up around 80 per cent of the All-Share index and so the blue chips heavily influence performance. Recently, it was the mid and small caps that led the way in the stockmarket. For example, between 2002 and October 2006, the FTSE 100 index rose by 31 per cent, underperforming the FTSE 250 index, which gained 89 per cent, by a whopping 58 percentage points. Trackers missed out as a result.

As it happens, large caps are back in vogue and many fund managers who played the mid and small cap game have increased their exposure to the bigger companies of late so tracker funds may wing their way up the performance tables once more”A passive fund will from time to time invest in the wrong asset allocation and in assets that will drop in value. The FTSE 100 tracker fund will invest in the poor-performing shares and sector of the index as well as the good performers whereas the manager will try and steer clear of poor performers,” says David Seaton, director of consultancy Rowanmoor Pensions. “The active manager will claim that their fees are met by enhanced performance.”

Indeed, active fund managers are always quick to knock passive investing. Take Schroders, for instance. It reckons that passive investing forces a manager to invest badly.

It says it is “entirely” backward-looking, with investors ending up committing high proportions of their portfolio to areas that have already performed well, and where the index weight has increased as a consequence, despite the fact that future prospects for such investments may be poor, or less attractive than other companies in the universe.

“Building stock positions to mirror an index can lead to significant value destruction,” says Richard Buxton, fund manager at Schroders. “By holding an investment in every company on an index, in direct proportion to each company’s market value, it follows that as a company gets bigger, your exposure to it grows. As it gets bigger, it is not necessarily getting better value. As a company becomes better value, your exposure will be less. Would any rational person take this approach in any other area of their finances?”

Buxton’s opinion is all very well but very few fund managers consistently add value (although Buxton’s record suggests he does deliver). According to Citywire, there are more than 930 fund managers in the UK managing retail money yet it only gives a rating to around 200.

What’s more, you only have to read the financial press to discover that the majority of fund managers underperform year in year out. As Mark Dampier at Hargreaves Lansdown, an avid fan of active fund management, says: “I know that many active funds also underperform and the truth is that about 90 per cent of active funds are complete rubbish, too.”

Therein lies the quandary for potential investors. Have you the time or inclination to pick the best fund managers or will your company have access to them in its fund range? Patrick Race, principal at Mercer Consulting, says it has no particular house view but believes that active management can add value. He reckons that it is possible to find managers that will add 3 per cent and that is worth paying for.

But Race admits that passive can be an option for investors wanting exposure to an efficient overseas market such as the US, where decent active US fund managers are few and far between. “It is difficult to find a US manager that outperforms a benchmark so for US exposure a tracker may make sense but in an inefficient market such as emerging markets, it is far easier to find individuals who can outperform,” he says. “Plus trackers are very cheap.”

What is certain is that anybody investing in a FTSE tracker because they believe it is low risk is barking up the wrong tree.

The UK equity market is highly concentrated in comparison with other markets and the concentration has increased since the 1990s. While nearly 700 companies are listed on the FTSE All-Share, the top 10 stocks account for between 40 per cent and 50 per cent of the entire market. The largest companies also tend to fall into the banking, oil & gas, pharmaceuticals and mining industries so nearly half of a passive portfolio is invested in these four sectors alone.

Buxton adds: “Many commentators refer to passive funds as ‘lower risk’. They may be lower risk in relative terms – their returns will track overall market returns, less fees and running costs – but what consolation is this to an investor in a year when the market falls 10 per cent, with this poor performance driven by those four sectors?”

It is why several experts reckon that the argu- ment is not about whether active is better than passive at all. Rather, it is about asset allocation.

Race says: “The greatest risk to a pension is not necessarily trackers, it is having too much exposure to equities – there are more efficient ways of managing risk but for certain investors they remain the mainstay and they can play a role as part of a wider portfolio.

Rowanmoor also finds that the question of active or passive management is not as important as the asset allocation to meet the goals. “Active funds tend to be used for the more adventurous investors and passive for the cautious investor,” says Seaton. “However, it is not unusual to see a portfolio constructed with a mixture of both passive and active funds.”

Factors affecting retirement decisions would include health, job prospects, possible sudden inheritance or the sale of the business.

Seaton says that in cases there will be a requirement to retain the pension commencement lump sum (tax free cash) usually 25 per cent of the fund in low risk assets where the value is unlikely to drop. Often this is placed in secure passive funds. Similarly, if annuity purchase is likely to be soon a passive approach is usually preferred.

“Asset allocation is about investing within the acceptable risk profile of a client. Most clients would be very unhappy to see their fund drop by 30 per cent over a year in line with an equity index. This is an occurrence that can and does happen and it makes little difference whether the assets are actively or passively managed,” says Seaton.

“Of far greater relevance is exposure to other assets that are unlikely to drop in line with equities. Over the past few years, our more successful clients have had an asset allocation of around 50 per cent in equities, 25 per cent commercial property and the rest in cash, gilts and bonds. Such an asset allocation, passively or actively managed, has produced good returns without huge volatility,” he adds.

Advisers and consultants firmly believe that active fund managers can add value. Buxton says he is worried by some investors’ religious faith in black box (read passive) investing because a machine cannot read a set of report & accounts and interpret results. Again, that is as maybe but there are plenty of fund managers who don’t appear to be able to do so either.

Even many professional advisers have their work cut out picking the best. What’s more, fund managers jump ship frequently, some have prolonged periods of underperformance and over a 25-30-year timeframe, it is highly unlikely that one manager will deliver the goods throughout. Managers such as the Anthony Bolton’s of this world are few and far between.

No wonder many advisers also readily admit that for many people passive trackers will probably do a reasonable job over the longer term – but if they are used as part of a wider portfolio adopting the core-satellite strategy, whereby the tracker is the mainstay of the pension, so much the better.


Adviser’s view – Mark Dampier, head of research, hargreaves lansdown

“I cannot argue that passive funds should never be used. For those who can’t be bothered to research shares or funds, passive has a persuasive angle. With only a computer driving you, you don’t have to worry about fund managers changing jobs. Nor do you have to worry about serial underperformance.

“In my view, for many people investing in pension funds, particularly the young who merely just tick the default box for their pension, many would be better off in a passive fund than an insurance managed fund for all the reasons we all know.

“There is a need to distinguish between good quality companies and good quality companies that are actually cheap. Trackers don’t do that. They allocate capital according to size so you do get the position where everyone is trying to get full weightings of Vodafone when it was £4 and the price eventually fell to about 75p.”


Adviser’s view – Andrew Merricks, skerritts consultants

“If you seek to achieve above average performance, then selecting good active managers must be an advantage. If you are simply concerned about charges, then passive management will be your choice. There is only any point in paying active management charges as long as you are achieving consistent outperformance.

“I see no real benefit to having passive funds, even as a core, within a Sipp, provided that Sipp is being monitored. It is a different story for people in company pension schemes over which they have little control. Passive funds would probably be the better option in this case.

“The only other case for passive funds is in using something like an ETF for exposure to markets such as the US and Japan where it is very difficult to find any active manager who consistently beats the index.”

Swings and roundabouts

Swings…

  • Over a decade, the Virgin UK Index Tracking fund, which charges 1 per cent a year, has returned 72 per cent yet the FTSE All-Share index which it purports to mirror has soared 91.6 per cent. Even the best-performing tracker – F&C FTSE All-Share Tracker – has returned 86 per cent.
  • Deciding which tracker to go for can make a big difference. Between 2002 and October 2006, the FTSE 100 index rose by 31 per cent, underperforming the FTSE 250 index, which gained 89 per cent, by 58 percentage points.
  • FTSE trackers are not low risk. The UK equity market is highly concentrated. The top 10 stocks account for between 40 and 50 per cent of the entire market.
  • The majority of active fund managers underperform year in year out. According to Citywire, there are more than 930 fund managers in the UK managing retail money, yet it only gives a rating to around 200.
  • Fund managers jump ship frequently, some have prolonged periods of underperformance and over a 25-30 year timeframe it is highly unlikely that one manager will deliver the goods throughout.


Know your trackers
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 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, telecoms or pharmaceuticals. 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, on of the UK’s biggest tracker funds, 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 a main index, as forced buyers can cause price anomalies.

A famous incident surrounding a South African IT company called Dimension Data in 2000 highlights how the two types of tracker differentiate. On Friday September 15, 2000, Dimension Data entered both the FTSE 100 index and the All Share index. Its price rose sharply from £6.70 to £10 within minutes. But the following Monday, the shares plunged to £6.88. The trackers that bought the stock at £10 suffered a dip in performance while those trackers that bought the shares at the lower price benefited.

Many index trackers, by their very nature, had to buy the stock at the highest price. Both Virgin, which runs the UK’s biggest retail tracker fund, and Norwich Union bought at the top on Friday evening.

Legal & General played a different game. It bought a little of Dimension Data before it entered the Footsie and then increased this holding once the shares had dropped to the lower price.