Passive funds dispense with managers and simply follow, or track, their chosen stock-market index up or down. Most of these tracker funds follow either the FT-SE 100 or the All-Share indices. The best known are run by Virgin, Legal & General and Marks & Spencer.
The passive investment lobby has statistics to support the view that many fund managers in the City are overpaid and underperforming. Research from The WM Company shows most active fund managers underperform the benchmark stock market index. Out of 46 unit trusts investing over the last 20 years, only four outperformed the rise in the stock market overall.
This does not take into account the higher initial and annual management charges imposed by active funds, which go to pay fund managers' salaries and financial advisers' commission. These hamper active performance even further.
Passive funds typically charge an annual fee of 1 per cent or less, with no initial charges, compared to as much as 5 per cent on active funds, with annual charges of around 1.5 per cent.
Fund managers have to recoup this charge through successful investment performance before they can start increasing the value of their clients' funds.
Although some fund managers have consistently outperformed the index in recent years, and attracted a lot of funds as a result, the research shows how past performance is - as the adverts are obliged to remind us - no guarantee of future performance. When comparing consecutive five- year periods, it could find little or no connection between how top quartile funds performed in each time period.
Yet the successful fund managers can beat the index. Over the last five years, the Jupiter Income Trust increased by 213 per cent, compared to a 125 per cent rise in the All-Share index.
"Jupiter has proven that active fund management can add significant value," says Steve Glynn, the sales and marketing director. Index trackers have taken billions of pounds investments but Brian Dennehy, an independent financial adviser in Chislehurst, believes their best days are behind them.
He argues that the steady and often spectacular stock market increases may have propelled them upwards, but this is unlikely to last. "Index trackers generally do better in the latter stages of a bull run, but when the market drops, they have to chase it down."
He believes this will come as a shock to many tracker investors. "Many people have been convinced that trackers are low-risk, but they are not low-risk, and people could soon discover this."
Trackers can distort the market generally, particularly those that follow the FT-SE 100 index. "This index is currently driven up by just six or eight shares, primarily in pharmaceutical, banking and telecommunications, while nearly half the index is on a downward trend," he says.
"When the major financial institutions start to sell those shares, the trackers will sell also, propelling them down faster and further than is merited. This means the market will over-react to any change."
Mr Dennehy prefers actively-managed funds that can do something when the market falls other than track it helplessly down.
"For a medium-risk investor, I would recommend Newton Income, Jupiter Income, Save & Prosper Premier Income Fund and the Fidelity Income Plus. These are all high-quality funds."
As with all investments, you should diversify, in this case mixing active and passive funds to create a balanced investment strategy. Some suggest taking an index tracker as your core investment, with some active ones to provide balance.
Mr Dennehy sees it the other way around. "Choose a good active fund as your core long-term investment to see you through thick and thin. Then you can think about an index tracker, which will do well at certain points in the market cycle."
One of the drawbacks of actively-managed funds - the higher charges - can be offset by buying them through a unit trust discount house (see box for details).
These rebate most of the initial charges, which, instead of going into a financial adviser's pocket, go directly into your fund. You have to know which active fund you want, however, as you only get the discount if you buy without advice. Paul Penny, managing director with discount house Financial Discounts Direct, recommends active funds Jupiter Income, Invesco European and Gartmore European Selected Opportunities.
n Chartwell Investment Management, 01225 446556
n Chelsea Financial Services, 0171-351 6022
n Financial Discounts Direct, 0500 498477
n Hargreaves Lansdown, 0117 900 9000
n MGP Direct, 0800 783 0768
n TQ Direct Choice, 0800 413186Reuse content