How to keep track with active funds

Since I started writing a few months ago about the merits of index tracking funds, I have received a lot of comments from both inside and outside the fund management industry. Many have been polite and supportive, others, inevitably, less so. What is clear is that the argument about the merits of active investment strikes at the very heart of the nature of the investment management business. It also throws into stark relief the ambiguous nature of most people's attitudes to the question of risk and return.

As many active fund managers quite rightly point out, the case for index tracking funds rests on a curious paradox. The reason why most active fund managers fail to outperform the market averages has something to do with the fees and transaction costs which they incur. But it is also partly about the fact that stock markets are fundamentally competitive places where thousands of talented and highly paid people are in a struggle to outperform each other. By definition, if your objective is to do better than average, this contest is one which, in any given year, half of the contestants simply cannot win. To go on winning year after year becomes progressively harder still, which is why it is so rarely achieved over long periods of time.

The intensity of competition in financial markets is the hard kernel of truth which underlies the flawed academic notion that stock markets are efficient, in the sense that they discount all available information. The paradox is that index tracking only works because markets are competitive. Yet if everyone were to switch to an index-tracking strategy, the markets would cease to be competitive and the strategy would then cease to work. Everyone would be so busy chasing each other's tail that there would be nobody left to do the hard competitive analysis which is what makes most shares in the first place reasonably valued most of the time.

Quite when you reach the point is a matter for debate. Is it when 25 per cent of all the money under management is essentially following an index-tracking strategy? Or 50 per cent? Or 75 per cent?

There are as many answers as there are estimates of how much money is already invested in this way. (It is one thing to monitor how many pension funds, for example, are explicitly following an index-tracking policy - it seems to be about 25 per cent of the total - but quite another to know how many other funds are in effect indexing most of their money without explicitly admitting the fact.)

That there is such a point is not in doubt. My view, for what it is worth, is that we are still some way short of reaching the point at which the marginal returns to active management start to rise again. The number of people employed in the securities business world-wide, for example, continues to rise, as does the amount of money under professional management. While an increasing amount of research effort is now being channelled into places such as continental Europe and the emerging markets, there is no sign of any let up in the competitive monitoring of leading share prices in the established London and New York markets.

Even had we reached the apotheosis point for index tracking, which I am sure we have not, it still would not follow that for most ordinary investors active management was a better bet. It would then be a question of assessing the cost and risk of an active strategy, relative to that of taking what the market averages have to offer. The thing which most investors - and most pension fund trustees - seem to find hardest to accept is that, in stock market investment, average performance is a perfectly legitimate objective, especially if it comes in a bundle with low costs. This is only another way of saying that for anyone with a reasonably diversified portfolio of shares, the biggest influence on the way its value moves will be the way the market as a whole moves, not the performance of the individual shares.

There is no doubt that a few very successful professional investors can consistently outperform the pack over long periods of time (as it happens, I have written a book, coming out early next year, which profiles some of them). But unless you know how to pick them out, it does not follow automatically that you will be able to benefit from the fact.

If you are able to do so, or if you have the time to pick your own shares and to find a successful formula for doing so, then that is obviously what you should do. Just recognise, however, that the odds are that you will end up doing about average - or maybe worse.

Not all is lost, however, even if you cannot see your own way to outperform the market over time. One way to have consistently beaten the averages in the last few years has been to buy shares in the fund management companies themselves. Mercury Asset Management (which has just been bid for by Merrill Lynch), Perpetual and Invesco have all done exceptionally well for investors. Even M&G and Henderson have mostly kept pace with the index, despite having a number of internal and competitive issues to resolve.

What you get with one of the better fund management companies is not just the benefit of exposure to rising markets - their income rises automatically as the value of their funds under management goes up - but also the chance to buy back (as it were) some of the juicy management fees that make active management such an expensive business in the first place. The party does tend to stop when stock markets go into reverse, however - so, in opting for fund management company shares, you are still partially back in the business of trying to call the market yourself. And that, as we know, is the hardest part of it all.