Investors are constantly being warned about the potential for losing money before they invest, which is worrying enough in itself, but then they hear statistics about the large number of active funds that fail to beat a benchmark and their plight seems even worse.
The claim goes that a majority of active funds underperform their benchmark over a long time-period and that to avoid underperforming the market, investors should choose a passive fund instead.
This idea is very powerful, because it creates the impression that there are a lot of people making easy gains that you can settle for rather than taking extra risk in the search for higher rewards.
The idea that your neighbour may beat you by buying a simple tracker even if you put a lot of effort into choosing the right active fund is a strong motivation for investors to settle for the passive option.
Some people claim the reason that most active managers underperform is down to statistics: skill is irrelevant to their returns, but anyone who beats their benchmark is lucky and those who do not are unlucky. This is a fairly extreme view.
A more common argument is that fees drag the majority of funds below their benchmark, and that the majority of managers may have actually outperformed in terms of their investment decisions, only for their funds to be dragged down by the compounding effect of charges.
Ultimately, though, everyone agrees that a large number of active funds do outperform their benchmark.
The argument against trying to select one is based around the fear of missing out easy gains that your neighbour has made.
However, something that investors often forget is that passive funds are also affected by fees, and can also underperform their benchmark.
All index-tracking funds must necessarily underperform their benchmark net of fees if they are simply buying and selling the constituents of the index rather than taking action to offset those losses.
It is true that the average IMA UK All Companies fund, which takes the FTSE All Share as its benchmark, has underperformed it over 10 years.
However, FE Analytics data shows that the average All Share tracker has also done so, and has underperformed by a greater degree, returning less than the average active fund.
Performance of funds vs benchmark over 10yrs
Source: FE Analytics
Advocates of trackers will point out that these products have become more sophisticated over the past 10 years, which is undoubtedly true.
Some funds use derivatives to minimise their costs, while others use stock lending to gain back what they charge to investors in fees, ensuring that they can match the index rather than lag behind it.
However, active management has also developed, and fees have been coming down across the board in response to pressure from consumers – partly caused, it has to be admitted, by the success of passives.
However, investors can only guess at whether passives will manage to reduce and offset their costs better than active funds, which is not a reliable way to invest.
Another issue that investors rarely consider is exactly what they buy with a tracker: how the index is constructed.
As head of FE Research Rob Gleeson pointed out in a recent article, the major stock market indices are typically dominated by companies with certain characteristics.
These tend to be in the utilities, tobacco and consumer durables sectors, along with oil, gas and mining companies.
In buying a passive, the investor may think they are getting simple exposure to a broad universe of stocks and sectors, but in fact they are overwhelmingly exposed to a very limited set of companies in a few sectors of the market.
Buying index trackers that follow different countries’ markets will not solve this problem, Gleeson explains.
This is because the companies at the top of the various indices tend to be the same from country to country – although there are some exceptions, such as Apple in the US.
This means that there are minimal diversification benefits to holding trackers on the main markets, particularly in such a globalised world economy where they move increasingly in step.
The main drivers for the indices are all the same, meaning that they can be expected to do well in the same circumstances, making a mockery of the notion of diversification, which is expressly intended to avoid this.
Data from FE Analytics shows that the FTSE All Share, S&P 500, FTSE World Europe and MSCI World indices have displayed a high degree of correlation over the past three years.
Correlation of indices over 3yrs
| Name | FTSE All Share | FTSE World Europe Index |
MSCI World |
S&P 500 |
|---|---|---|---|---|
| FTSE All Share | N/A |
0.96 | 0.90 | 0.74 |
| FTSE World Europe Index |
0.96 | N/A | 0.91 | 0.73 |
| MSCI World |
0.90 | 0.91 | N/A | 0.93 |
| S&P 500 | 0.74 | 0.73 | 0.93 | N/A |
Source: FE Analytics
This trend is likely to continue, as the place where the company is listed is now of limited significance.
Most companies listed on the London Stock Exchange are multi-nationals that have found it convenient, or financially beneficial, to be listed here and the same applies for those listed in the US.
On top of these issues, investors need to consider how these tracker funds behave in a sell-off.
In a recent article, FE Trustnet showed how tracker funds were much harder hit by the recent market dip than active funds, presumably because the active funds could avoid the more cyclical and overvalued sectors that suffered the most.
This is not to say that passives are useless or that they have no place in your portfolio, but investors need to be aware that they are not a solve-all solution to the risks of investing.
