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Much-lauded index funds may not always be top for shrewd investors

It takes a mentally-strong person to be a fund manager.

Fund performance tables are published every day and it is simple to compare how each fund has performed against its peers at any time.

How many of us would be able to sleep well knowing every decision we made can be compared against every other person allegedly doing the same job? It must be made even worse when you go home and read in the paper that for most of the time the job you do could be done better by a computer simply tracking an index.

I am fed up reading that investing in actively-managed funds, with a human making the decisions as to what the fund invests in, is not worth it and that the majority of managers fail to beat the index.

This argument, which largely focuses on the difference in fees/charges, has gained even more traction after Warren Buffet, the world's most well-known active manager, is quoted as having instructed his executors to invest the bulk of his fortune into an S&P 500 index tracker fund when he dies.

A good number of commentators have been espousing for years, to readers of the financial press, to ignore active funds and stick with simple index trackers with the interesting logic that lower fees will/must result in better returns.

So how has that advice panned out? Well if during the May bank holiday five years ago you had invested into the L&G UK 100 Index Fund which tracks the FTSE 100 and has no human involvement, your investment would have grown by just under 77 per cent. Excellent you may be thinking, but is it? Well actually, no. This low-cost investment is ranked only 215th out of 256 funds over the five years, with the average fund in the sector having grown by more than 94 per cent, that's 17 per cent more, even taking into account those horrid fees. The short- term performance of the tracker fund is no better being ranked 241st out of 284 funds in the last year. How can this be?

Well it may have something to do with the nonsensical fact that investing in a fund that tracks an index usually means that the bigger the company, the more of your money will go into it. Shell, HSBC, BP and Glaxo are the four largest companies in the UK and if you invest in a FTSE-100 tracker fund, more than 21 per cent of your money will be in these giants. This is not an investment decision based on their future prospects but one that is solely based on the total value of the shares they have in issue.

We have talked for many years about the herd mentality among investors. But as advisers, we come across fund managers who also believe in safety in numbers, and as a result feel that they need exposure to the largest companies to ensure they do not under perform against the index. When we hear this we tend to give them short shrift. We understand there will be times when funds will under perform against the index. However, we have a lot of time for managers that stick to their guns during such times as more often than not it pays off.

We met Neil Woodford last month. For as long as I can remember Neil avoided owning any banks within his funds — and during the early 2000s banks made up more than 25 per cent of the index. At that time I attended a dinner in Edinburgh hosted by Neil at which a ginned-up veteran stockbroker insisted that Neil really must own banks, particularly Scottish ones. I bet the old boy's clients hit the gin bottle too in 2008.

Steven Forbes is managing director, Alan Steel Asset

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