THE JONATHAN DAVIS COLUMN
The meaning of the word inert, says my dictionary, is "having no ability to move or to resist motion; inactive, lazy or sluggish". Not exactly complimentary, is it? But inertia is a much misunderstood lady, at least as far as the stock market is concerned. Take a look, for example, at the figures in the table, which comes courtesy of the investment trust analysts at NatWest Markets.

The table is the product of a technique which the NatWest analysts choose to call "inertia analysis". The idea is to try and measure how much difference the investment decisions of investment trust managers have actually made to the value of their funds over time.

This is how it works. What NatWest does is to take the portfolios of some of the largest investment trusts at various dates, typically one, three, five, 10 and 20 years ago. They then look at how the assets of the trusts were split at the time: how much in the UK, how much in the United States, how much in Japan and so on. They then calculate what the trusts' performance would have been had the managers at the time frozen the fund and gone to sleep, leaving the weightings of the funds unchanged.

It sounds complicated, but really this is a fairly straightforward exercise in number crunching. When the computer produces the "what if" figure, the analysts simply compare it with the actual performance the fund managers have managed to achieve over the same time frame. Divide one figure by the other and, hey presto, you have a simple, albeit crude, measure of how much "value" the manager has added through his decisions over the years. A positive figure in the table shows that a trust has outperformed its relevant "inertia index"; a negative figure that it has failed to beat a policy of doing nothing.

But here's the rub: for many investment trusts, over quite long periods of time, they don't outperform the "do nothing" portfolio. There are always plenty of negative percentage figure in the tables, meaning that inertia, inactive, sluggish or lazy as she may be, has consistently the better track record.

In fact, to take an extreme example, if you apply the inertia analysis to the 10 largest international generalist investment trusts, and look at their performance over 10 years, not one of them managed to add any value on this score. The figures range from Monks, the best with a 2.7 per cent shortfall against its inertia benchmark, to Scottish American, which came up nearly 22 per cent short of the value a no-change portfolio would have produced.

Over other periods, the picture is more balanced, with some trusts doing better than inertia, and others failing to do as well. When NatWest widened the sample to include the 24 largest trusts for which this exercise could realistically be carried out, only over one year did more than half the trusts do better than the relevant "do nothing" index. Most years, most general investment trusts failed to add value. The fund manager could have stayed at home, which would at least have saved on his management fees.

Now at this point one has to enter some important caveats. As Hamish Buchan of NatWest says, the inertia exercise is not as precise as it could be. There are some technical reasons why the comparisons may not be as fair to investment trust managers as they should be. In periods when sterling is strong, for example, you would expect trusts with large international holdings to do less well than a composite index figure.

A second interesting point is that outperforming the inertia index does not in itself guarantee that a trust will be among the best performing in its sector when you measure absolute returns. The reason for this is that no amount of skill can make up for being in the wrong markets in the first place. If you are running a large and well-diversified portfolio, as most of these investment trusts are, picking the right markets to invest in is more important than picking the right individual stocks. Any manager who has stayed fully invested in the United States during the last legs of the bull market there, for example, will have done better than anyone who invested in Japan, even if the latter beat the Tokyo index by a mile and the former failed to keep pace with the Dow Jones index.

Fund managers could also argue that the long term of, say, 10 years is made up of a succession of short terms, say, one year, where they have done relatively well. So inertia has her limits. The caveats should not be allowed to disguise the importance of the general conclusion, however. The lesson, which we already knew from studies of unit trust performance, is that it is very difficult for professional investment managers to outperform the market averages consistently over time.

Once you take the cost of hiring the manager into account, then tot up the transaction costs involved in buying and selling so many shares, the returns often don't justify the expense of active management. This is just another way of saying index funds have a lot going for them. They don't absolve you of the need to decide how much money you should have invested in the stock market, but they provide a relatively cost effective way of gaining that exposure.

Equally, just because inertia has proved to have such a good track record, it does not mean that investment trusts are necessarily a poor place to invest.

Because of the discount factor - the fact that the asset value and share price of an investment trust don't move hand in hand - the reverse can often be the case. If you buy when discounts are low, and they subsequently move in your favour, investment trust shares will produce a better return than either an index fund or the equivalent unit trust. For the past three years, with discounts widening, returns to shareholders in the bigger investment trusts have suffered. Most have underperformed the All Share index. But over the longer term, there is no need to write off the big generalist investment trusts.

One can't leave the subject without a word of praise for the fund managers at Scottish Mortgage and Scottish Eastern (run by Baillie Gifford and Martin Currie respectively). Over one and three years, they have managed a distinguished double - coming high in the rankings for absolute returns and also beating a policy of inertia investing as well. In Edinburgh, at least, someone is still flying the flag for active investment.

Top and Bottom Value-Adders

Sample of 24 over three years and 10 over 10 years

+ is outperformance in per cent

- is underperformance in per cent

Three years

Top Bottom

Monks +6.9 British Empire Secur -14.8

Scottish Mortgage +6.7 British Assets -12.6

Scottish Eastern +4.5 Dunedin Worldwide -10.0

Scottish Investment +4.2 Scottish American -9.8

Securities Tst of Scot +2.1 Second Alliance -6.2

Ten years

Top Bottom

Monks -2.7 Scottish American -21.6

Alliance -2.8 Witan -17.5

Foreign & Colonial -3.1 Scottish Investment -15.7

Second Alliance -3.2 Scottish Eastern -10.7

Scottish Mortgage -5.0 Anglo & Overseas -6.9

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