MARKET COMMENT
Closet Index Trackers

By James Carlisle
February 22, 2001

The WM Company has released its third annual report on the relative merits of index trackers and managed funds. The reports are commissioned by Virgin, who clearly have many eggs in the index tracker basket, though WM's independence is beyond doubt.

The report, which can be downloaded from Virgin's website, focuses on the extent to which managed funds can be considered "closet trackers". The theory is that many fund management companies are so frightened of the potential bad publicity from a significant underperformance of their benchmark, that they don't really give themselves the opportunity for significant outperformance.

In essence, a fund manager might see that Banks have a weighting in the FTSE All-Share of 15.9%. She might then decide that, since she's "bearish" about banks, a weighting of only 14% is appropriate: a small bet against banks. Looking at the weightings of the companies within the banking sector, the fund manager sees that HSBC makes up 35% of the banking sector so, preferring this share to the others, she takes a weighting of 50% (that is, 7% of the fund) in HSBC and makes up the remainder of the weighting in banks with the others. Of course, for Banks and the individual companies to maintain their relative weightings, there must be someone somewhere making the opposite bets.

This conservative top-down approach defeats the object of active fund management. The managed fund is just tending towards being a tracker with a rather large "tracking error". WM found that 42% of supposedly actively-managed funds deviated from the index by less than 3% per year over 5 years and a further 34% had a deviation of between 3% and 6% per year. That leaves just 24% deviating from the index by more than 6% per year. Over the same period, the mean deviations from the index of trackers was 0.2% to 2.3%. So a large proportion of managed funds simply look like expensive trackers with a slightly larger than normal tracking error.

The other interesting point to come out of the report is that buying several different managed funds makes it even more likely that you've just found an expensive way to track the market. This is entirely logical. Let's go back to our fund manager with her underweight position of 1.9% in the banking sector (that is, 14% against the index weighting of 15.9%). As we noted, someone somewhere must be taking an opposite bet. If we buy a second managed fund, then there's a fair chance that we'll find the fund manager who's 1.9% overweight in banks. Perhaps he also has a particular aversion to HSBC...

WM found that selecting just one active fund gave you an 18% chance of outperforming the index by an average of more than 2% per year over five years (before charges). Buying 3 managed funds reduced this to 12% and a portfolio of 5 managed funds gave only an 8% chance of outperforming by more than 2%. An index tracker will provide a similar result but, by charging less, it is very likely to perform better. No wonder Fools like them so much!

Where next?

Learn about trackers and compare them in the Fool's ISA Centre
Read about WM's findings for yourself
Index trackers discussion board