Data suggests that more often than not, actively managed funds underperform their benchmark over the long-term, thanks in no small part to the eroding impact of charges.
It is no surprise, therefore, that many investors have long given up searching for consistent outperformers and settled instead for tracker funds or ETFs with much lower charges.
Some investors invest purely in passives, using them to implement their asset and regional allocation decisions in a cheap and straightforward manner. Some retail funds have even been launched with this approach to investing, including Marlborough ETF Global Growth and the Architas MA Passive range.
While Jason Hollands (pictured), managing director of business and communications at Bestinvest, thinks there is a compelling case for using passives in a diversified portfolio, he thinks it is unwise to rely exclusively on them as they do not give investors enough diversification.
"Passives are not a panacea and are only as good as the index they map, and the reality is that many indices are very concentrated around their largest stocks and sectors," he explained. "Therefore, the supposed diversification a passive offers is to a degree a complete illusion." "For example, the UK indices are so heavily skewed to oil and gas and banks, you actually wouldn’t get a usefully diversified industry exposure investing exclusively through passive funds."
These comments come in light of a warning from FE Alpha Manager Toby Ricketts, who is backing stockpickers over passive funds because they have a greater ability to avoid problem areas.
Hollands adds that the high concentration of trackers means that investors are denied access to important areas of the market, because their weighting in the index is pale in comparison to the largest companies.
"To illustrate this, I would point to the fact that the FTSE All Share – which technically gives you exposure to over 600 companies – is 38 per cent invested in the 10 largest shares," he explained.
"In fact, the 100 largest stocks represent 85 per cent of the market and the next 250 a further 13 per cent. That means that 350 shares account for 98 per cent of the index."
"In contrast, small caps have a tiny 2 per cent share of the index, despite the fact that they account for most of the individual stock opportunities once AIM is included."
"Whole industries would be squeezed out of your portfolio if you took an exclusively passive approach, such as technology, which only represents 1.5 per cent of the All Share and 5 per cent of the mid cap space."
It is possible to get exposure to niche areas of the market via specialised passives. A growing number of small cap passives and ETFs, including the Vanguard Global Small Cap Index fund and iShares Core S&P Small Cap ETF, as well as even more specialised vehicles such as Close FTSE TechMARK and L&G Global Health & Pharmaceuticals Index.
However, Hollands does not believe buying passives in specific areas such as these is a good idea and recommends investors go for an actively managed fund instead.
"I don’t think there’s enough choice and a lot of these specialised areas have poorly constructed indices," he said.
"Moreover, I don’t think illiquidity suits a robotic approach such as this. These specialist areas tend to be less researched parts of the market, where some decent work can yield results."
A number of specialised funds score highly across FE’s numerous ratings. The AXA Framlington Biotech fund, for example, has five FE Crowns and is rated highly by the AFI panel, making it into the Aggressive Portfolio.
It has significantly outperformed the L&G tracker in recent years, with returns of 132.71 per cent since August 2008.
Performance of funds over 5yrs
Source: FE Analytics
Linden Thomson runs the fund. It requires a minimum investment of £1,000 and has ongoing charges of 1.77 per cent.
Other highly rated specialist options include FE Alpha Manager Evy Hambro’s BlackRock Gold & General fund and the five crown-rated MFM Techinvest Technology portfolio, as well as single-country options such as Invesco Korean Equity and Aberdeen Global Indian Equity.
