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Cutting out fund manager by switching to a tracker may bring greater returns

Many people would be better off with a cheap tracker fund instead of paying a high fee to a fund manager, according to research from Vanguard, the asset management firm.

Tracker or passive funds simply follow an index such as the FTSE All Share. When the market rises, so does the value of the fund. Of course, when the index falls, the fund also drops.

But trackers are cheap because they do not employ a fund manager. The annual management fee is about 0.2% - and the low cost can boost returns.

Active funds are ­different. The fund manager picks particular stocks and aims to beat the benchmark index. The fees are therefore higher - you can expect to pay an annual fee of 0.75% for an active fund.

The research seems to ­indicate fund managers are not worth the extra cost. In fact, most actively managed funds failed to outperform their chosen benchmarks over five, 10 and 15 years.

For example, nearly 70% of active global equity managers and more than 80% of active global bond managers lagged their benchmarks (their index) over the 15-year period between 1999 and 2013.

Much of the problem is the comparatively high cost of active funds as charges eat into returns.

James Anderson, manager of the strongly performing £2.4 billion Scottish Mortgage Investment Trust, told an Edinburgh conference last week that the costs of investment were the "single most important factor" affecting investors' returns.

Vanguard says an annual management fee of 1.33% a year on an investment of £100,000 would cost more than £180,000 over 30 years.

The firm's Dr Peter ­Westaway says: "Investors can't control the markets, but they can control what they pay to invest. Our research shows low-cost funds have a greater chance of delivering investment success"

The research is supported by Chase De Vere, the independent financial adviser, which shows that since 2009, the average US active fund is up by 57.5%, compared with a rise of 69.4% for passive funds.

But Patrick Connolly, certified financial planner at Chase de Vere, says: "It can be particularly difficult for active managers to outperform in more efficient markets such as US shares and large UK stocks, as information about individual companies is widely known so managers will struggle to find opportunities that their rivals have missed.

"In contrast, there is more scope for active managers in less efficient areas, such as the emerging markets or in small cap companies." Chase de Vere therefore recommends a mixture of passive and active funds.

Graeme Mitchell, ­managing director of Lowland Financial, a Glasgow-based independent financial adviser, tends to favour active funds, but recognises it's not always easy to select a winner. He says: "The trick is to pick the right fund, with a fund manager who adopts a consistent and disciplined approach. Of course, cost is also important as any fees will take a bite out of your profits."

Research last year for the True and Fair Campaign found what it called an "epidemic of copycat funds" - where managers were essentially tracking the index but charging for active management. It found 46% of UK equities funds had about 40% of their portfolio modelled on the make-up of the overall stock market.

Campaign founder Gina Miller said: "Investors are unlikely to be aware that they are often paying three times the fees of a typical index fund without owning anything significantly different. There is nothing fundamentally wrong with the construction of these funds but investors need to be fully aware of what they are buying and pay a fair price for it."

Many Scottish financial planners favour passive funds for their clients as a low-cost way to track different sectors of the market, not just a large-company index like the FTSE-100.

Alan Dick, principal of Forty-Two Wealth Management in Glasgow and a Scottish spokesman for the Institute of Financial ­Planning, says: "In order to provide significant out­performance, managers need to create highly concentrated portfolios that differ significantly from the index.

"This is a major gamble for investors. If it pays off, the manager is a star - if it doesn't, he is a flop."

However, Stuart Dunbar at Argyle Consulting, who also represents the Association of Professional Financial Advisers in Scotland, comments: "Passive funds have their place. But when markets are volatile and you look at the record of good fund managers, I know where I would rather be."

Advocates of the passive approach point to a statistical survey by Standard & Poor's covering five years, which found only one-quarter of all actively managed funds did better than the index, one-quarter did slightly worse, one-quarter did much worse, and one-quarter did so badly they had to be quietly wound up or merged.

Steven Forbes, managing director of Alan Steel Asset Management at Linlithgow, admits that up to 70% of managers fail to beat the index, but insists: "The great thing about the stock market is you can see those managers who have failed to achieve it and those who have done it. We don't just look at performance, we meet the managers to find out how they do it - was it a flash in the pan or do they have consistency?"

The firm's principal Alan Steel comments: "People often write that the average fund fails to beat an index - why would you buy an average anything?" Steel cites the Newton Higher Income with a total return of 500% over 20 years, way outstripping the "average" UK equity income fund with 345%, and close to the 350% total return of the all-share index - which unlike the others shows no charges deducted.

Even better is the stonking 728% return of the Invesco Perpetual High Income fund, whose manager Neil Woodford left Invesco to set up his own fund amid a welter of marketing hype this month.

Steel says the firm intends to continue to follow Woodford's star. He concludes: "We see it as our job to find the outstanding managers who are always disciplined to stick to a system through thick and thin."

CASE STUDY

IAN Winstanley of Edinburgh has been investing in equity funds for many years, using the stocks and shares Isa allowance - which jumps to an annual £15,000 in July.

Last year he gave up on cash Isas because of the low rates, and moved those holdings into the Fidelity Moneybuilder Dividend, an equity income fund.

Winstanley, 69, pictured with wife Gail, says: "I personally never use tracker funds, not on a point of principle but because by luck or judgment the funds I have had have done all right."

He goes on: "I have only ever been with Fidelity, their range is enormous, I have always trusted their managers and I study the literature they provide."

The DIY investor says he sees no reason to pay a financial adviser. "Based on my humble experience of these things, I don't actually see the point in paying for another layer of advice from the chap down the road, who probably doesn't know much more than I do."

ACTIVE INGREDIENTS

Research from Pemberton Asset Management earlier this year claims active managers have actually outperformed passive funds since 2010. "The passive lobby has long been vocal about the inability of active managers to beat their relevant index, but the returns from 2013 and indeed over the past three years point to the opposite," Pemberton said.

The average fund in the UK All Companies sector returned 26.1% compared with a 20.8% return for the all-share index, while the average UK Equity Income fund made 25.2%. Over three years the returns were 35% and 38.6% respectively against 31% for the index. In the more specialist UK Smaller Company sector even the average fund made 37.2% (one year) and 53% (three years).

Pemberton says: "One of the reasons for this active outperformance is that several of the larger stocks in the index, which the passive investor is compelled to hold, have produced poor returns." Tobacco giant BAT, HSBC and Royal Dutch Shell had made only single-figure returns in 2013, Rio Tinto was flat, BHP Billiton was down 8.9% and Glencore down 11%.

Pemberton notes that active managers typically hold a bigger percentage of small and mid-cap stocks in their portfolios, and this style of stock has significantly outperformed the large and mega-cap stocks that dominate the FTSE All Share Index.

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