Although some 30% of the UK market is now made up of tracker funds, slavishly following the benchmark is not the best way to achieve outperformance in the current climate of volatility
Over the past few years, trackers have made inroads into the investment management community, so much so that index tracking now accounts for some 30% of the UK and 35% of the US markets.
This is perhaps not so surprising with hindsight, given the fact the world has enjoyed a 20-year bull market. Over this time, making a passive decision to invest in the index has meant a good percentage gain.
During the late 1990s, the tracking industry, epitomised by Virgin, was highly successful in using past performance statistics to prove to the investing public that putting money in trackers was the cheapest, easiest and lowest-risk option to play. However, as we all know, past performance can be a dangerous factor to use when choosing funds.
My personal view is that trackers have not been the best thing to buy since the market peaked towards the very end of 1999.
We had a final surge in terms of the strong blue-chip rally between 1997 and 1999, which gave further impetus to the tracking brigade as a number of top stocks dominated the market. This led to an overvaluation of blue chips compared to the mid and small caps, which were completely left behind.
The use of statistics to prove anything means we all need to be careful. Indeed, the statistics on passive investing are very strong and probably a fair indictment of the active fund management industry.
Those with longer memories may recall the use of past performance statistics in a Hoare Govett survey put together around 1986 entitled The Smaller Company Effect. This broadly suggested that over the previous 20 to 30 years, investing in small caps had led to significant outperformance of the main market.
The conclusion was that by backing smaller companies, which can grow far quicker than blue chips, investors would significantly outperform the main market. This led to a further rush into smaller companies.
The consequence was that it marked the high point for the sector, which went on to underperform for more than 10 years, not really reviving until the start of 1999.
The concept that trackers are lower risk is certainly an odd one. They are only lower risk if you are following a low-risk benchmark because they themselves become that benchmark. Most clients are actually more concerned with absolute risk. The top 15 stocks in the UK account for some 63% of the market and this concentration in just a few stocks, which are on a P/E of about 22, does not appear to be low risk to me.
In addition, the FTSE is dominated by four big sectors: banks, pharmaceuticals, oil and telecoms, again some 60% of the market. These sectors tend to be negatively correlated with each other. In other words, when one goes up, the other goes down. What is the result? The market moves sideways. A sideways movement of the main benchmark is hardly conducive to good investment from a tracker point of view.
The market could end up being roughly at the same level it is today in a few years time. Don't believe me? Just look at the Dow Jones from 30 December 1966 to 30 December 1982. The index broadly moved between 800 and 1,000 points, at one time dipping below 600.
Tracking the index over a period of sixteen years would have hardly made you any money at all. A consequence of this is that a buy-to-hold strategy may not work over the next few years.
Of course, if the dips in the market were successfully traded, a tracker would have worked well, but most people buy a tracker so they will not have to make those decisions. Indeed, surely it is a decision to back a computer without the worry of fund managers moving that drives many people into this area of the market.
The past 20 years have been good in investment terms, with few down years in either decade. However, if we go back to the 1950s, 1960s and 1970s we see a complete change. In the 1950s, there were four out of 10 down years, in the 1960s, six out of 10 and in the 1970s five out of 10.
This might suggest a scenario where genuine active investment should start to outperform. Indeed, my belief is that we may be in a golden age of active investment.
But, of course, there are only a few managers you can back and it is those who are not benchmark orientated that are likely to make the most money for clients.
In a trendless, directionless market, experience will be a hugely important factor. In many respects, investors should be looking among the older guard. This means fund managers like Bill Mott, Anthony Bolton, Andy Brough and Tim Steer, to name but a few.
These are fund managers who don't slavishly follow a benchmark but look for absolute rather than relative returns, precisely what most private clients want.
Mark Dampier is head of research at Hargreaves Lansdown
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