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Stand out from the crowd

28 April 2015

How active fund managers are using their skills to outperform the returns of those tracking an index.

There was much fanfare in February when the FTSE 100, the index of the UK’s leading shares, finally closed above the peak achieved in December 1999, before going on to break the 7,000-point mark in March for the first time. But despite the celebrations of the record high, there was actually little for investors to celebrate – a zero return over 15 years is pretty poor.

However, only those investors who chose funds that tracked the FTSE 100 – and who were unlucky enough to have bought right at the top of the market – will have had to wait that long for their investment to recover.

Many active fund managers have made good, positive returns over the past 15 years. Yet passive, or index tracking funds, are enjoying a surge in popularity: according to statistics from the Investment Association, trackers accounted for 11.3% of funds under management at the end of January, up from 9.7% a year previously.

The FTSE 100’s performance over the past 15 years is a clear demonstration of the pitfalls of passive investment. Back in December 1999 internet fever was at its height and technology, media and telecoms (TMT) companies accounted for more than a quarter of the index. In hindsight, that was a classic bubble and the share prices of most TMT companies fell sharply. Passive funds tracked the boom and subsequent bust.

The technology boom was an extreme example, but stock markets are often characterised by dramatic shifts in sentiment towards particular sectors. In the run-up to the financial crisis in 2007, banks were in great demand; both for their dividends and their growth prospects. Now, many of their share prices are a fraction of their peak and many of their dividends have been cut or suspended. The benign economic climate in the early part of this century, and the emergence of China as a leading economy, sent the shares of mining companies soaring amid predictions of the start of a commodity supercycle. The global economy is now much more subdued, as are mining share prices.

Skilled active fund managers, who decide where to invest regardless of the composition of their benchmark, can identify these periods of over-optimism and avoid buying stocks at inflated prices. Indeed, one of the UK’s most admired managers, Neil Woodford, was criticised for shunning tech shares when the hype was at its peak, although their subsequent performance meant his decision was vindicated.

Index tracking funds, however, have to ride the booms and busts. As they have to own the entire index, or at least use quantitative techniques to replicate it, they can only mirror its performance. Indeed, while the charges on tracker funds are typically lower, once they are taken into account an investor must, by definition, do worse than the index. When markets are rising, investors may not be too upset with that – although active fund managers may be performing better. When markets are falling, however, tracker funds are exposed; while a skilled active manager may still be finding opportunities to make profits or to protect investors from the full effect of the drop. Richard Rooney, of Burgundy Asset Management, points out that indices can be very poor quality: the one in his native Canada, for example, is particularly prone to bubbles and cycles.

‘We have a global mandate for St. James’s Place that is measured against the global index. There are a lot of high-quality companies in the index, but there are a lot of low-quality companies, too. In theory, if there are companies in an index of poor quality and with poor management, you could do better with an active investment strategy.’ An active approach can also avoid the risk of a portfolio being excessively skewed towards a small number of sectors or companies. The current FTSE 100 is dominated by banks, oil and gas, and pharmaceutical companies, which together account for around a third of the  index. It is also an international index, with global companies such as BP, Unilever and GlaxoSmithKline making a large proportion of their revenues overseas. A passive fund tracking the FTSE 100 will inevitably be heavily exposed to these sectors; an active fund manager will take their own view on the prospects of these companies and sectors and construct their portfolio accordingly.

Active investors can take a long-term view, holding on to shares that fall out of favour in the expectation that they will recover. Rooney believes that a patient approach is one of the important factors in generating long-term returns. ‘You have to accept that there will be periods of underperformance. But, if you have clients who know your style and process, and if you concentrate on continuing to do what you have always done, investors should be rewarded for their patience.’

Tracker funds, by contrast, have to sell shares when they fall out of the index – and have to keep adding to their holdings if the shares rise; and so the company becomes a bigger proportion of the fund, regardless of whether that rise is justified or overdone. Not all indexed products pay dividends, which are a vital part of total investment returns: indeed, the FTSE 100 may only have marked time in share price terms between December 1999 and February 2015, but if dividends are included, the return was 66.3%. Investors in a tracker fund without dividends risk missing out on that crucial part of returns.

Of course, not all indexed products track the FTSE 100: there are also products tracking the FTSE All-Share, regional and sector trackers, and a growing range of specialist trackers following more esoteric indices or niche areas. Some of the more specialist tracking products can have a place in an investor’s armoury – for example, to provide exposure to geographies where there are few active managers – as a risk management tool or as part of a diversified global portfolio.

But investors should be wary of being taken in by the apparent simplicity and cost advantages of a purely indexed approach. Indexation can actually be higher risk than active management – as the technology boom demonstrated. Taking a contrary view can mean there are periods when performance lags but, over the long term, a skilled active manager should produce returns ahead of the index. As the legendary investor Sir John Templeton said: ‘It is impossible to produce superior performance unless you do something different from the majority.’

The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested. Past performance is not indicative of future performance.

FTSE International Limited (“FTSE”) © FTSE 2015. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

Some of the products and investment structures documented within this article will not be available to our clients in Asia. For information on the funds that are available please get in touch.

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