Jonathan Davis column
Why pay over the odds for an actively managed fund when you could buy an index tracker?
Saturday 30 August 1997
Under its new chairman, Martin Taylor, Barclays has made a conscious decision to try and build a dominant position in the index-tracking business and, given the head of steam that is now building up behind indexed funds, not just in the United States, but in other markets too, this is beginning to look an increasingly shrewd strategic decision. Index funds are even starting to gain a foothold in Japan.
Two years ago the bank's investment arm spent $440m on buying Wells Fargo Investment Advisers, a Californian firm which was the original pioneer of index-tracking and the first to appreciate how computer power could make such a "product" feasible. (For those interested, the story of how the concept developed is well told in Peter Bernstein's excellent book, Capital Ideas.)
Since then, the evidence of how poorly many (but not all) actively managed funds have performed has continued to accumulate, and the business has continued to grow to the point where Barclays now has around $350bn of investors' money around the world in so-called passively managed funds.
This makes it the market leader in this business in both the United States, where the main rivals are State Street and Bankers Trust, and in the UK, where the main competitors to date have been NatWest and Legal & General.
The vast majority of this business is in the institutional market, where an increasing proportion of pension funds have switched to investing some or all of their assets in index-tracking funds. But Barclays also has plans to introduce both indexed funds and funds based on what it likes to call its "advanced active" techniques to the retail market. We should see the first results here shortly, when it unveils plans to rationalise and improve its range of unit trusts next month.
Its aim is to increase its share of the unit trust market in two main ways: by using its branch network to sell a simpler and more user-friendly range of funds directly to the public, and by offering a range of more sophisticated funds through independent financial advisers. Whether or not the range will include a pure indexed fund at this stage remains to be seen, but it looks a good bet before too long.
If so, it will be a further, welcome competitive development in the retail market, and will give investors who are looking for low-cost but sensible savings products a wider choice than before. Last week's conversations prompt me to three further observations about the whole "active versus passive" debate, which reaches into virtually every aspect of the investment business, and is still not widely understood.
One is that the reasons why the tide is still running strongly in the direction of passive management are both powerful and well-founded. It is important to emphasise that this is not just because of the consistently poor results achieved by the majority of active fund managers over the past 20 years, although that is obviously the starting point.
Barclays makes the point that the trend to indexation in all the main markets has invariably followed the arrival of performance measurement systems which have made everyone aware of the under-performance problem. The power of computers and the revolution in investment theory, which has transformed the way we think about risk and return over the past 20 years, are just as important factors.
The second observation is that the kernel of the debate about indexation is as much about managing risk and obtaining value for money as it is about achieving the best possible returns. The argument against many active managers is in fact not that they often fail to deliver the results they advertise, but that they charge a high price for chasing an objective which for many investors is simply not worth paying for, even if it were deliverable, while also carrying unnecessary extra risk.
Put at its crudest, what is the point of paying 1 per cent or 2 per cent a year in management fees in order to try and achieve a return of, say, 9 per cent a year (which could be 6 per cent if it goes wrong) when you can reasonably expect to achieve 8 per cent for a cost of next to nothing?
The third comment to make is that saying there is a good case for many investors to put some or all of their money into an index-tracking fund is not the same as saying there is no point in putting any money at all into actively managed funds. It is true that one of the arguments behind indexing is the assumption that stock markets are broadly efficient - that is to say that the market is reasonably good at valuing shares on the basis of available information and that therefore active fund managers have to be exceptionally good (or lucky) in order to outperform consistently.
In general, that is true, but there are also many exceptions to the rule, just as there are many successful strategies for finding these mispriced securities. Interestingly, Barclays Global Investors acknowledges this fact, and is busy marketing what it calls "advanced active" funds alongside its index-tracking funds.
Its research suggests, for example, that it is possible to achieve outperformance by tracking stocks where there has been a recent change in sentiment (as reflected in earnings estimate upgrades by brokers analysts); on the basis of movements in the pattern of directors' dealings in their own company shares; and on certain valuation considerations.
What they are now doing is using their computerised technology to construct index-matching funds, and then tweaking these funds for extra return by adding carefully controlled bets of this kind. Results so far seem promising.
The general point for most investors remains that you have to know what you are doing and be prepared to pay for the results. What has changed is the starting point of all this. Until now, investors have started with the assumption that active management is the best option. Anyone looking for reasonable risk and return today should start with the assumption that an index-tracking fund is his best bet and it is up to the fund managers and his advisers to convince him that paying more for active management is worthwhile.
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