Are fund managers serving a dog's dinner?

The reputation of the fund-management industry has been at a low ebb for the past few years. Stock-market turbulence combined with chronic underperformance and the widely reported problems at some management groups, such as New Star, have led many investors to simply give up on the cult of the big-name fund manager.

And, with the publication of investment advisory group Bestinvest's Spot the Dog report, the industry's fragile reputation will sink even lower.

The report highlights chronic underperformance by fund managers as measured against the stock-market indices they are supposed to beat. A fund is collared with "dog" status if it has underperformed the index over each of the past three years, and by at least 10 per cent over the same three-year period on a cumulative basis. Giant fund Jupiter was hit with the dog tag due to the performance of its massive Income fund. Other names in the firing line included Schroders, Scottish Widows, Henderson New Star and Fidelity.

For many investment experts, these results only serve to reignite the debate of active versus passive fund management, and highlight the risks involved with investors who rely on individual fund managers for their returns. "What the dog-fund list does do is highlight to investors the need to review their choices regularly and understand what they are investing in," says Danny Cox, from independent financial adviser (IFA) Hargreaves Lansdown.

But management groups foisted into the role of dog-fund worst in show are less pleased with the process. Alicia Wyllie, a director at Jupiter, defended the performance of its Income fund, pointing out that the fund had been identified by Bestinvest as a potential outperformer only last spring.

Whatever the arguments, passively managed tracker funds are an increasingly popular option for many investors, experienced or otherwise. The attraction lies in their simplicity and relatively low cost. As a result, many financial experts tout these funds as the ideal investment choice for anyone lacking the confidence to handpick individual shares or sectors.

Tracker funds work by mirroring the actions of a major stock-market index, such as the FTSE 100, without the need for investors to select the right funds, sectors, or shares. Because trackers closely follow the movements of a major index, returns are less volatile than if one invested directly in one company. With actively managed funds, investors are relying on the skills of a manager to buy and sell stocks in an attempt to beat market expectations and outperform the index, rather than match it.

"Passive funds are more suitable for less sophisticated investors who want to take a less hands-on approach to investing, those who intend holding their investment for the longer term and are less willing to speculate," says Dan Clayden from IFA Clayden Associates.

Also, with annual charges of 0.25 per cent to 1 per cent, passive funds are significantly cheaper than actively managed funds, which can charge between 1 and 2.5 per cent per year. Exchange traded funds (ETFs), a new breed of tracker, can cost even less, with annual charges of only 0.2 or 0.3 per cent.

Crucially, ETFs offer wide-reaching access to more unusual investments, from commodities such as gold to the Vietnamese market, for example, as well as a huge variety of country-specific trackers. Unlike traditional trackers, ETFs are traded like shares and listed on the stock exchange. They can therefore be traded in the same way as shares through stockbrokers. Big ETF providers include Lyxor, Barclays' iShares, and Invesco PowerShares.

One of the principal benefits to ETFs is that they can be held in individual savings accounts (ISAs), Self-Invested Personal Pensions (Sipps) and Child Trust Funds. This allows investors to tailor their portfolio in terms of exposure, risk and tax efficiency, all without the need to rely on expensive and often unreliable fund managers.

However, it is important to remember that passive funds have limited potential. They serve to mirror an index, not beat it, and once costs are taken into account they will always lag behind that index. "Although 90 per cent of active funds do not beat their benchmark after fees, you could say 100 per cent of passive funds do not beat their benchmark after fees," says Mr Cox.

Where actively managed funds can potentially come into their own is when markets are expected to fall. Any index can suffer if a dominant sector falls. For example, the FTSE 100 is highly vulnerable when the banking sector struggles. An active fund manager can move into cash or other safer assets while a tracker is compelled to follow the direction of the chosen index – no matter which direction it's heading.

The key to successful investment in actively managed funds is picking the right active managers, and this can enable investors to reap the rewards of performance way above the market, but this is easier said than done. "There are good active fund managers but it is almost impossible to identify who they are going to be in advance," says Christopher Wicks, from IFA N-Trust.

What's more, he adds, good fund managers are likely to be poached by another company, leaving investors high and dry.