FOOL'S EYE VIEW
Trackers Win In Bear Markets

By James Carlisle
March 22, 2002

It's often said that 'trackers do badly in a bear market'. After all, just as they track the market upwards when it's going up, they'll track it downwards when it goes down. On the other hand, it's said that the managers of actively-managed investment funds can move some of their money into cash and wait for the market to start going upwards again. It sounds logical but, when you look at it more closely, it doesn't stack up. The reason is that the stock market doesn't have a predictable direction. It is never going upwards and it is never going downwards. It has only ever gone somewhere.

As a child, my grandfather would take me and my sister on 'beano rides'. This would involve us all going off in the car and him tossing a coin to see whether we'd turn left or right at the next junction. It sounds pretty pointless, and of course it was, but it was also fantastic fun. Anyway, at the end, we'd have travelled along a clearly defined route. But at no stage of the journey could we have said where we were going to go next. The stock market is a beano ride and, whatever they tell you, fund managers are as much in the dark about its immediate direction as the rest of us.

It has to be this way. Imagine what would happen if all the fund managers in the City decided that we were about to move into a 'bear market' and that they should switch assets into cash. Bosh! We'd not so much have a bear market, as a full on crash. What's more, it would be impossible for them all to reach the exit in time. Since it's their selling that actually causes the fall in prices, it must be the case that the average active fund manager (or, to be pedantic, their average pound invested) just follows the market downwards.

An index tracker will also follow the market down but, by charging less, they'll have tended to do better than most - just as they'll have tended to do better than most when the market has gone up.

In the light of all this, it's no surprise to hear the WM Company, in their annual report on active versus passive fund management, saying that the majority of actively-managed funds did worse than the index through last year's market fall. The report is commissioned by Virgin Money, who have plenty to gain from plugging the index tracking approach, but WM is highly respected and it would be hard to dispute their independence.

Anyway, the Report covers the unit trusts in the UK All Companies sector. Of these 260 funds, only 93, or 36%, managed to beat the index in 2001. So much for moving out of shares and into cash! As your time period gets bigger, the argument for index trackers just gets more and more persuasive. Over the five years from 1997 to 2001 (inclusive), only 30% of active funds outperformed the median index tracker.

Having said all that about the market's unpredictable direction at the beginning of this article, I'll have to contradict myself, because the market does have a very clear direction over the long term, and that's upwards.

Not only are trackers very efficient at getting these long-term returns but, by tracking the market, you also take away the risk of seriously missing out. In the five years to the end of 2001, the best performing index tracker outperformed the FTSE All Share index by 0.5% a year. The worst performing index tracker was 1.0% a year below the index. The gap, when taken over the full five years would amount to a total difference of about 7.7%. The actively-managed funds, on the other hand, vary from underperforming the index by about 7% per year to outperforming by about 11% per year. Over the five years, that would put the best-performing fund at about double the value of the worst performer.

The WM Report concludes:

Whilst we have shown that tracker trusts do provide somewhat divergent performance, the selection of a tracker trust is a reasonably straightforward exercise. The selection of an active trust is anything but straightforward.

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