Personal Finance: Richard and Nicola, place your bets

The most hotly contested argument among investment groups at present concerns the relative merits of actively-managed funds versus trackers.

So fierce is the debate that it descends at times into farce. As evidence of this, last year Richard Branson of Virgin even placed a pounds 6,000 bet with Nicola Horlick, of SocGen Asset Management, with the winner pledging to give the money to a charity of their choice.

The high-level bet was that a pounds 6,000 investment in Virgin's FTSE All Share tracker will outperform Ms Horlick's UK growth fund over a three-year period.

"A third of the way through, and the Virgin investment is now worth some pounds 6,033 - against pounds 5,612 for the SocGen fund, after all charges," according to Tony Wood who works for Virgin Direct.

While active fund managers pick the companies they buy and sell using different investment criteria, tracker funds do away with this selection. They either mirror or buy all the shares in a chosen index.

So, will employing a professional fund manager, who has spent years honing his or her investment skills, give a better payback than an investment in a passively-managed fund such as a tracker, where little fund management is needed?

Performance results over recent years show that most active managers fail to outperform the market. There's an old adage in the City, the so- called "72/25 rule". This states that at any given time, three out of four fund managers will produce a worse return for you than if you had put your money into the FTSE 100 or the FTSE All Share, the two main stockmarket indices.

The underperformance of the majority of active managers is worse when charges are taken into account. The most popular tracker, or passive funds, typically have initial charges of less than 1 per cent and annual management fees of under 0.75 per cent.

For example, Legal & General, who have the second largest tracker, valued at over pounds 1bn, has no initial charge at all and an annual charge of 0.5 per cent.

Compare this with an actively managed fund that typically has an initial charge of 5 per cent or more, along with annual charges of 1.5 per cent. This means that in the first year of investment, it has to beat the index by well over 6 per cent in order to match the performance of a popular tracker.

Recent research conducted for Virgin Direct, the manager of the largest UK tracker fund, has fuelled the argument. It looked at the past 20 years' experience of balanced funds, the sector that includes all UK unit trust trackers, as well as those actively managed funds whose aim is a combination of growth and income.

Its main findings not only confirmed that most funds failed to beat the index over any period, but also that those active funds that achieved a top-quartile place over any five-year period subsequently lost their place at the top over the next few years.

"It is the shares within the FTSE 100 and All Share indices that have shown the greatest growth," says Tony Wood. "Smaller and medium sized companies that have the potential to get bigger are where active managers most like to invest. But these have failed to keep pace with the UK's largest blue-chips."

Last year, while the FTSE 100 rose by almost 17 per cent, and the FTSE All Share went up nearly 13 per cent, the majority of medium and smaller companies failed to keep up. Trackers will always do slightly less well than their chosen index, because of their charges, even if these are extremely low.

As Bob Yerbury of Perpetual explains: "The more active a manager, the worse the performance appears to have been in these markets.

"Last year, for example, if you picked stocks outside the index, it was a disaster. If your analysis at the start of 1998 was that blue-chips were over-valued, you then found that it was all one-way investment traffic in favour of these companies during the year."

However, the way the stock market has moved over the past couple of years also carries inherent dangers, according to active managers. Companies in the FTSE 100 now account for almost 80 per cent of the whole stockmarket. In fact, the combined value of the UK's 15 largest companies amounts to nearly half the total value of all shares listed on the Stock Exchange.

This concentration on just a small number of companies has never been seen before. "This polarisation of the market is very unusual," says John Hatherly of M&G. These companies are all in the financial, telecom, petrochemical and pharmaceutical sectors. So there are risks if these sectors suddenly go into free-fall.

"Some trackers could be dangerous," says John Ross of Fidelity. "They are meant to be for the more risk-averse investor, but in volatile markets, if these 15 companies were to fall out of favour, their performance could plummet."

There is a feeling in financial circles that much of this concentration on large companies has happened owing to the very popularity of tracker funds.

At least 20 per cent of all stockmarket investment being done today is via tracker funds that invest on behalf of pension funds and other financial institutions, as well as private investors.

The actual amount may be much higher, as there are believed to be a significant number of other funds shadowing the indices while charging active management fees.

Since the beginning of this year, there are signs that companies outside the FTSE 100 could be beginning to outperform the blue-chips. And while these may prove to just be straws in the wind, it could also be a return to the pattern of stockmarket activity seen before the current bull-market which started in 1994, when medium and smaller companies outpaced their larger rivals.

"Active management will make a comeback," says a very confident Bob Yerbury.

"Then, the private investor wants to be with one of the 25 per cent of active managers that will outperform the trackers."