Jonathan Davis column

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Indy Lifestyle Online
Do any of you have your money invested in an index-tracking fund? The chances are you do not. Most private investors still have the great bulk of their savings in unit or investment trusts run by so-called active fund managers - those trying to do better than the stock market averages.

Yet it is a racing certainty that this is soon going to change. The growth in so-called passively managed funds has been a notable feature of the past five years, but the bandwagon still has a long way to run, not just for private investors (for whom the technique is particularly well suited) but for institutional investors as well.

This is what Warren Buffett, the great American investor, has to say on this subject: "Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.

"Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."

His point is not just that it is notoriously difficult to do better than the market as a whole, year in year out, but that even those investors who are clever enough to find a handful of fund managers who can outperform the index on a consistent basis are likely to find the benefits eroded by high fees and transaction costs.

This is the reason why, on average, four out of five actively managed funds fail to provide their investors with a return that exceeds the return on the market as a whole. Mr Buffett reckons that in the United States, where competition among mutual funds is greater than in this country, the average cost penalty associated with having an actively managed fund is about 1 per cent a year.

This logic is compelling, given that most private investors don't have the time or the skill to pick either the best managers or the best stocks by themselves. (For those who do have the time and the skill it is a different matter.) Index-tracking funds are cheaper than actively managed funds by quite a margin, and costs are falling. The emergence of an active futures market in the main stock market indices means it has become possible to construct an index-tracking fund more cheaply and more simply than before.

The argument for index-tracking funds has been given an important boost by the recent Office of Fair Trading report into the provision of private pensions in this country. The OFT argues, sensibly in my view, that the best way most ordinary people can provide themselves with a reasonable pension is to invest in an index-tracking fund. This should be predominantly invested in equities but, the OFT suggests, it make sense for the percentage of equities in this kind of fund to be reduced over time, so that the risk of the pension's final value being damaged by a sudden market fall as retirement approaches is reduced.

This seems an eminently sensible proposal, to which it is hard to find valid counter-arguments. One of the main drawbacks is that, aside from Virgin Direct, few such pension products are currently available. As we know from the pensions mis-selling scandal, the pensions that private sector providers have sold have, in many cases, been inappropriate products sold at a ridiculously expensive price.

It's hard not to agree with Paul Klumpes, of the University of Lancaster, one of the contributors to the OFT report, that the commercial incentive for the rest of the industry to make it available is simply not there.

Such a commodity product is not something that is ever going to make huge profits for the provider, although any firm which can grab a reasonable chunk of the market would still have a nice business on its hands. Nor is there much incentive for independent financial advisers to recommend index-tracking funds, when there are bigger commissions to be earned on actively managed funds.

As a general rule, I am no fan of regulated solutions to problems of this kind, but it seems to me that there is a clear case, as Mr Klumpes suggests, for using the regulatory system to encourage the provision of a "plain vanilla" low-cost index-tracking pension fund product. We all have a vested interest in the country having a well-funded and appropriate level of pension fund provision in place. The cost of providing one through the state is very high, and there is an argument for clearing away any impediments to the introduction of a sensible privately funded system.

One of those impediments, as Mr Klumpes says, is the information barrier. Most people do not know where to go to look for information about an appropriate private pension, and lack the skills to interpret the information even if they could find it. Although there are private sector services which analyse and rate the performance of different fund managers and their products, this information is not widely or cheaply available.

At the same time, there is no uniform set of disclosure rules imposed on the fund management companies. This is one reason why they all seem able to produce figures which show their performance in a flattering light.

An index-tracking fund with a relatively high equity content is an appropriate investment for someone seeking to provide for their pension. The Law of Unintended Consequences being what it is, it is quite likely that if such products are introduced in this country, they will be introduced at exactly the moment when the stock market takes a dive. If inflation persists, a higher gilt component may be appropriate. But even that is a difficulty which should not obscure the fundamental truth.

There are many good reasons for choosing an active fund manager, and some reason to believe that you can achieve superior performance that way, but for pensions there is no need to chase that extra margin when there is a cheaper and more reliable alternative available. Take it from Mr Buffett (who does know how to achieve superior investment returns), even if you won't take it from me or the OFT.