Tracker funds: I rest my case

AFTER SEVERAL hectic weeks, this week we saw the first semblance of normality returning to the financial markets. It is too early to be confident that the extraordinary volatility we have witnessed in virtually every major market over the past couple of months has finally abated, but what seemed like incipient panic in some quarters has started to die down at last.

It is true that one of the technical reasons for the volatility in certain markets has been the enforced unwinding of positions held by some of the troubled hedge funds which have run into difficulty. This has allowed those on the other side of their deals to make merry at their expense.

Historically - and curiously - the stock market has always been twice as volatile in the last three months of the year as it is in the middle of the year. But there is little question that this year at least the historical pattern will be reversed: if we were to have double the exceptional volatility we have already seen in the markets since August, then we would be in for the mother and father of all bear markets. Although the economic outlook is highly problematic, and it seems likely that shares will fall further during the next six months, I don't yet see a Doomsday-style bear market as the highest probability outcome.

The recent market turmoil makes it a good moment to return to one of the favourite topics of this column in recent months, namely the performance of index-linked or tracker funds. Warren Buffett and Professor Paul Samuelson are among those who say that most ordinary investors should build their investment portfolios around a core holding of index-tracking funds. I share that view.

The argument for making index funds the core of your investment portfolio is the well documented fact that only a minority of actively managed funds outperform the market consistently over any length of time. Even for those which do, the rewards from an active investment strategy are only rarely good enough and/or consistent enough to justify the higher fees you have to pay a fund manager for the privilege of employing him.

One of the arguments which is often heard against index funds however is that while they may earn their keep in normal times, they are vulnerable to bear markets. "Just wait until the market turns gloomy," goes the refrain from the active management brigade.

Allied to this is the perfectly valid question: can it really make sense to invest in a fund which you know for certain is going to go down in value every time the market as a whole goes down? Surely that has to be a peculiar investment strategy.

Well, now at least we can look back on the recent market ups and down and see what the evidence is. For unlike all previous market crashes, the current sharp fall in share values around the world is the first major market correction in this country during which index funds have existed. (The big proliferation of index funds over here has been in the last three years, though in the United States they have been common for longer, where they are still steadily gaining market share).

What is the evidence of the past three months? Well, according to Micropal's Fund Expert service, the index funds have indeed behaved largely as predicted - they have gone down, across the board, echoing (though not always matching) the market's overall moves.

In September the All-Share index fell 3.7 per cent, having taken an even nastier fall (10.35 per cent) in August. Its three-month return to the end of September was -13.89 per cent: over six months it was down 14.57 per cent, although at the end of September it was still up on the year by 2.01 per cent.

How have the index funds compared? Given the way that the FTSE 100 and the All-Share indices have diverged in performance over the last two years, it obviously depends a fair deal on which index the tracker fund you choose is seeking to emulate. But the range of returns over three months from the 14 UK equity index funds that specifically track the All-Share index has been from -11.9 per cent (the best) to -16.24 per cent (the worst).

As you would expect the returns are bunched more or less equally on both sides of the benchmark index's performance, with the number of underachievers marginally outnumbering the overachievers. Beyond a year, the index tracking funds all inevitably lag the All-Share index by small fractions, reflecting the additional costs that they have to bear. The Footsie 100 tracker funds have all done materially better than the All-Share index, thanks to the continued outperformance of larger companies.

So the tracker funds have by and large fulfilled their mandate. But what are the equivalent figures for actively managed funds? Have they demonstrated the superiority flexibility which their advocates claim? According to Fund Expert, there are 454 unit trusts which can be broadly categorised in the UK equity sector. Of these, just 56 (or just over 20 per cent) have outperformed the All-Share index over the past year.

Over three years, out of the 404 funds which have been active all that time, the figure is just 28. And over five years the proportion falls to just 19 out of 310 funds that have been going that long.

No fund whose primary function is to invest in equities has managed to avoid losing value, and even if you look at the highly regarded funds, just as many have underperformed the index as have outperformed it during the big market correction. Over the three months to the end of September, out of the 454 funds in the broad UK equity sector, the number which outperformed the All-Share index was just 171.

There is no surprise in these figures. When you bear in mind the fact that all actively managed funds are considerably more expensive than the best index funds, the performance record does little to damage the index fund case. In fact, it merely reconfirms their positive merits. As I have said before, passive versus active is not a simple either-or-choice. Investors can sensibly mix and match a core index holding with an actively managed top-up if they so choose.