When in doubt, sit on the fence

The fall in the stock market raises questions about pooled investments

To track or not to track? This is the question uppermost in the minds of hundreds of thousands of small investors as they ponder the next likely movement in the UK stock market.

The issue has acquired major significance in the past few weeks as the seemingly inexorable rise of shares in the FTSE 100 index appears to have ground to an uncertain halt. Hence the detailed attention paid to the subject by several writers in this week's section.

So, how long will this "hiccup" last? Does it mean that index tracker funds, which have delivered outstanding performance in the past 18 months or so, thereby attracting a gigantic wall of investors' money, are now no longer the place to put one's money into? Should one now be concentrating on the next rung of so-called "mid-cap" stocks in the FT 250 index, for instance?

Tony Wood, marketing manager at Virgin Direct, whose All Share tracker PEP has gobbled up the biggest single chunk of savers' money, is forthright about his company's investment strategy: "We do not ever try to predict the way the market is going to go. We simply argue that trackers offer good long-term value."

For all Mr Wood's frankness, the past two days' falls in the Footsie confirm the increasing need to reach a judgement on what is happening. For many experts, the experience confirms a view they have held for many months about the Footsie and the All Share indexes (which reflect the dominant influence of blue-chip stocks).

Premier Unit Trust Brokers is a Bristol-based firm specialising in so- called "pooled" investments such as unit trusts. Its latest bulletin suggests the reason Footsie shares have done well depends at least in part on the growing trend among giant US pension funds to seek overseas investments in large companies, whose stocks can be quickly liquidated if need be.

"The preference for large liquid stocks by US fund managers, including those running tracker funds, has put a firm imprint on all markets, including our own," writes Peter Edwards, a partner at Premier.

Generally, a handful of sectors - banks, oils, utilities and pharmaceuticals - have been responsible for most of the Footsie uplift. In particular, cash has poured into a handful of shares: HSBC, Lloyds/TSB, Glaxo, SmithKline and Shell. "Conversely, the FT 250 and Small Cap [stocks] are overweight in the `wrong' sectors," Mr Edwards adds.

This, along with the appreciation of sterling compared to other currencies, has meant that smaller companies without major international exposure have found foreign markets difficult to export into.

Political factors, in which foreign investors began betting on the inevitability of a Tory election defeat and a consequent rise in interest rates under Labour, meant the pound remained at high levels, exacerbating the trend.

Mr Edwards is rueful about these factors: "In the past, we have tended to consider that trackers were funds to invest in during an economic downturn. This does not appear to be happening now."

But he points out that the Bank of England's recent statement that further upward pressure on sterling may finally have been checked by recent interest rate rises underlines the Bank's commitment to keep inflation under control.

The Bank's view, coupled with the most recent base rate rise on 6 August, led to a drop of about 3 per cent in the Footsie, while the FT 250 rose by more than 4 per cent.

It is this adjustment which recently led some observers, including Bill Mott, head of UK investment at Credit Suisse, to suggest that a fall in the value of the pound would eventually allow small company exports to power ahead, along with their share prices.

Not everyone agrees. Andy Jackson, small companies fund manager at Hill Samuel, another respected investment house, says: "We would be reluctant to say that small-cap companies will outperform. Our view is that large [company shares] are still likely to do better."

"Ah, yes, but," say the fund managers, "should the rise falter, the ability to pick the right stocks in a generalised market downturn means we will begin to recover lost ground."

This argument is not entirely true. Earlier this year, The Independent looked at how trackers performed in the aftermath of three share price downturns.

The result was that in each of the three periods - 1987, 1990 and 1994 - trackers bounced back at the same speed as many of the best funds in their own sectors.

Of course, a question mark still hangs over the ability of trackers to outperform managed funds at a time when the market begins a slow downward spiral running over a year or two, as in the mid-1970s. Then, genuine stock-picking might come into its own.

So what should investors do? Mr Edwards' view is simple: "I believe we should sit on the fence for the moment."

By that he means accepting that - given the money from the US pouring into them - safety of sorts will come, for the time being, from larger and more liquid stocks.

But that does not negate the potential for stockpicking at the same time or from the mid-cap markets, where the gap with the Footsie has closed. The time may have come for investors in tracker funds to look at funds which can combine both aims, delivering the best of both worlds.

Is fence-sitting the best of both worlds or just a painful exercise? Only time will tell. But in the meantime, those of nervous disposition might want to give it a try.