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To track or not to track

By Ian Millward, published 14 May 2021.

To track or not to track, that is the question?

Tracker funds have come a long way since they first established a foothold in the UK market in the early 1990’s. But the relationship between supporters of active and passive (tracker) funds has rarely been a comfortable one. Certainly, amongst financial advisers and wealth managers, the tendency is to subscribe to one or other school of thought and then vehemently and dogmatically refute the credentials of the other.

For most ‘old school’ wealth managers, active funds still dominate whereas the new breed of ‘robo’ advisers favour passive management. Our approach has always been more pragmatic. Both have strengths, and weaknesses, and we use a combination of the two. But with opinion so divided, what led us to that decision? Is it still the right one? And if it is, why doesn’t everyone do it?

Let’s start with some theory before considering other factors that might come into play. A key argument for tracker funds is based on something called the ‘Efficient Markets Hypothesis’. In short this means all shares are priced to reflect all publicly available information, so no amount of analysis can give an investor an edge over others. On this basis you cannot beat the market, so you might as well track it.

However, supporters of active management argue (and history suggests) the market is not perfectly efficient. Warren Buffet has described investing as a means of transferring money from the impatient to the patient and at times there can be enormous cognitive biases at play leading people to either under or overreact depending on the mood of the time. Whether it be the extremes of Dutch tulips, tech bubbles or crypto there are countless examples of investors and markets being consumed by either fear or greed and therein lies an opportunity for good active managers.

Both camps can make strong theoretical arguments and provide empirical evidence in support. The empirical case in favour of trackers is, without doubt, stronger and why so few active funds outperform may be worthy of a blog in its own right! Nevertheless, I don’t think it is too much of a stretch to accept that markets are driven by people and are not, therefore, always perfectly efficient.

So, what might lead wealth managers or advisers to subscribe so wholeheartedly to one approach or the other? Here are just a few to be getting on with.

Before trackers came along fund managers and advisers had a very cosy relationship. The primary reason for using an adviser was based on their claimed ability to pick the best performing funds. The advice was ‘free’ to the client as the adviser was paid commission by the fund manager they selected.

Tracker funds literally declared war. Not only did they refute the ability to select outperforming funds, but they also didn’t pay commission. They immediately disenfranchised, both fund managers and financial advisers. Battle lines were drawn, arguments carefully rehearsed, and attitudes formed. And once formed unwinding these beliefs does not always come easy.

But reasons can be much subtler than this. People often enjoy an element of complexity in their role as it positions them as an expert. Meeting, listening to and talking about fund managers is interesting and stimulating work. Advisers and wealth managers build research teams; individuals build careers and these decisions become deep rooted in the fabric of a business.

However, that doesn’t mean that all those who track are necessarily more altruistic. A recent FCA study established that the average UK client pays around 2.2% a year in total charges i.e., advice, investment, and platform. So, one of the, albeit smaller, national advice firms has worked out that using trackers to slash the underlying investment costs allows them to increase their own share of the pie to 2% a year. That is an extreme example, nevertheless there is a definite trend amongst advisers to increase their fees towards 1% a year and one easy way of masking this is by using trackers to reduce costs elsewhere.

There can also be arguments about practicality. Active funds involve a lot more work. For example, for us, it is not just the work in researching and monitoring funds; it is also the complexity of placing deals, re-balancing portfolios as well as then managing expectations when funds don’t always immediately outperform. Tracking is simple and easy by comparison.

And we do periodically debate whether we should just move to a portfolio of trackers, but it is more wishful thinking on our part. Only something like 20-25% of active funds outperform their index over a 5-year period and, even if you select amongst them, only about 25% will manage to repeat that. If it came down to performance alone there would be a good case in favour of keeping it simple, playing the odds, and investing purely in trackers.

But it is not just about performance and tracking in isolation brings its own limitations. We often include infrastructure, and sometimes natural resources, in our portfolios and, in the past, we have included physical assets such as gold and property. Tracking works in large efficient markets but is not viable, or even an option, in every sector.

Similarly with interest rates at 0.1% and governments investing billions in quantitative easing (which effectively means buying back their own bonds), the fixed interest market is an environment where there are good arguments against exclusively tracking.

And let’s not forget that tracker funds are blind and simply reflect the world in front of them. The aforementioned tech bubble of the late 1990’s was a great example of this when ‘dot coms’ shot up in value only to crash back to earth at the start of the new millennium. Even today, Vanguard’s U.S. Equity

Index invests in an impressive 3,950 underlying companies but just six of those: Apple, Microsoft, Amazon, Facebook, Alphabet (Google) and Tesla currently account for 17.9% of the total value of the fund.

By the way, that fund is the largest holding in the Vanguard LifeStrategy 100 Equity Fund and the third and fourth largest holdings have similarly high weightings in those six businesses. We are not predicting a bubble, and we are certainly not criticising Vanguard. But I think it highlights why we continue to believe that a blend of both active and passive funds represents the ‘sweet spot’ between risk and reward.

Why doesn’t everyone do it this way? We certainly don’t claim exclusivity on running sensible portfolios, we are simply confident that our way is, at least, as good as any other. But I will leave you with a couple of thoughts. It is well known that Warren Buffet, the world’s most famous investor, is a strong supporter of tracker funds. It is perhaps less well known that Vanguard, the champion of trackers, include and actively support actively managed funds within their range. As with many things in life, success involves balance.