Outlook: Active fund managers find their place in the sun one

ACTIVE FUND managers have struggled to keep up with the market in recent years, but finally they seem once more to be getting their place in the sun. Pension funds achieved a rate of return of 2.9 per cent on UK equities in the second quarter of this year, according to the latest WM Company survey, well ahead of the index return of 2.3 per cent. This is the second quarter in succession that active managers have outperformed, and although the degree of outperformance is hardly anything to write home about, this has none the less been a welcome respite from the onwards and upwards march of the index trackers.

Unfortunately, two swallows do not a summer make, and many of the actively managed funds will have since started to underperform again. The cyclical and smaller company shares which sustained them in the first half of the year have come off the boil with a vengeance, particularly in the last few weeks, undermining the performance of many "value" driven funds. So is it game, set and match to the low-cost passive managers afterall?

By no means. The smarter active fund managers who combine the value approach with a degree of growth stock selection are continuing to win mandates with the big pension funds, despite their higher charges. If investing in both value and growth stocks sounds a bit like indexation in disguise, this is because it is. Even so, clever stock selection should still allow the actively managed fund to outperform by avoiding the real losers and maintaining a reasonable smattering of winners. It is managers that concentrate exclusively either on value or growth techniques that seem to lose out to the trackers in the long term.

Both techniques have their strengths, but they tend to come into their own at differing points in the economic cycle. Value concentrates on stocks that appear to have become oversold and look cheap relative to the worth of their assets. In theory, everything eventually returns to norm, so those assets ought one day to start earning a reasonable rate of return again. The upswing in value stocks therefore tends to come in periods when economic growth is beginning to accelerate from a low level and inflationary expectations are starting to rise once more. This leads to the anticipation of greater pricing power and higher earnings.

This served the value funds well in the first half of this year, but where's the inflation and the pricing power? The evidence is that it is just not coming through. Companies are finding it ever harder to push through price rises. The recent rise in interest rates and the pound will make it tougher still. So it's back to growth stocks again - high value companies like mobile phone operators with potentially very high levels of growth. If the future is as Gordon Brown, the Chancellor, sees it, one of high growth and very low inflation, then this is where the value will lie, not in traditional value stocks.

The cleverer active managers will have balanced these factors in their appraisal of the future, and are now busy proving that it is indeed possible to beat the index over the long term - albeit not spectacularly. To do that, you have to go out on a limb. And if you go out on a limb, you will by definition eventually end up spectacularly underperforming.

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