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Ricketts: Why I’m switching out of passives and into actives

22 July 2013

The manager of the Margetts International Strategy fund says the popularity of trackers in recent years has caused a “Ponzification” of certain indices.

By Alex Paget,

Reporter, FE Trustnet

We are finally moving into a stockpicking market, according to FE Alpha Manager Toby Ricketts (pictured), which has prompted him to chop down his passive exposure in favour of actively managed funds.

ALT_TAG Ricketts, who manages various funds of funds at Margetts, has long advocated the use of passives – especially US-focused ones – not only because they are cheaper, but because there is a lack of managers who can add value.

His three largest holdings in the Margetts International Strategy fund are Vanguard US Equity Index, Royal London US Tracker and L&G US Index.

However, Ricketts says that is all about to change.

"The reason we have those funds is because we have a big focus on charges, but equally because the US market is so efficient, meaning active managers have notoriously struggled to add value," he said.

"However, we have had a number of meetings this week discussing the issue. We feel that active managers can start to add value. Trackers surged in popularity and that was one of the main reasons they [active managers] struggled to outperform."

Ricketts’ main reason for ditching his passive exposure is down to his belief that money will increasingly flow out of ETFs as stockpickers become more popular, which will hinder funds that merely track an index.

"We are starting to see money coming out of ETFs," he said. "We think that trackers are basically self-fulfilling."

"It has happened in the past, like in the late 90s. Vodafone made up 10 per cent of the FTSE so every time an investor bought a tracker, the share price kept going up and up. It can be a process of 'Ponzification', really."

"Active managers won’t buy those sorts of stocks because they think they are crazily overvalued, but in the short-term their underweight has meant they would underperform."

"We feel that the craze for trackers could well be coming to an end. I’m just using the experience of the late 1990s and the early 2000s and I think there will be an economic environment of both winners and losers."

"Investment fundamentals will be back in favour, which will hurt trackers, which are effectively blind."

"We have been on the tracker train for a long time and it has rewarded us well. However, we have seen 200 or so ETFs closed recently, which suggests that money is coming out of trackers and pushing us towards a stockpicking market," he added.

Ricketts has managed funds in the IMA universe since January 1995.

Our data shows that over 10 years, Ricketts has returned 135.43 per cent, while his peer group composite has returned 100.92 per cent.

Performance of manager vs peers over 10yrs


Source: FE Analytics

Two of his standout funds are Margetts Venture Strategy and Margetts Select Strategy.

His Select Strategy fund is a top-quartile performer in the IMA Mixed Investment 40%-85% Shares sector over five and 10 years. His Venture Strategy fund is a top-quartile performer in the IMA Flexible sector over five years and has the second-highest returns in the sector over the last decade.

Although Ricketts says he will be decreasing his passive exposure to the US, he has not decided which active managers to invest in.

"The fund to buy is probably currently in the third quartile," he said.

"We are going to be looking for managers that have a process we like. That means they may have been underperforming because of that process, but it will hopefully be one that resonates with the new market conditions," he added.

He says he used to hold Schroder US Mid Cap and Schroder US Small Companies, both of which are run by fellow FE Alpha Manager Jenny Jones. Ricketts also holds AXA Framlington American Growth within his portfolios; however it only makes up a small percentage of his assets.

"We do like the fund and its process, but the performance has been dreadful. However, as I said, it is another example of a fund that could benefit from a change in conditions," he said.

According to FE Analytics, AXA Framlington American Growth, Schroder US Mid Cap and Schroder US Small Companies have returned roughly the same as the IMA North America sector over three years, but they have all underperformed against the S&P 500 index.

Performance of funds vs sector and index over 3yrs


Source: FE Analytics

Rob Morgan, pensions and investment analyst at Charles Stanley Direct, agrees that investors should also be wary of the concentration risk involved with passive funds.

"Some people are staunch advocates of active investing, whereas for others, cost is the most important consideration – and that means going down the passive route where charges are generally lower," he said.

"Yet one important risk of passive investing, which I believe often goes unnoticed is concentration. Although markets contain a wide range of companies, they are concentrated towards the very largest."

"In extreme cases, certain indices are over-exposed to one or a small number of stocks or sectors that have a large impact on performance," he added.

He says this can be particularly problematic with emerging market trackers, although it has also been the case with passive funds that track the likes of the FTSE All Share and the S&P 500.

"In more mature markets, individual stock concentration is not so much of an issue, but you can still find yourself unwittingly skewed towards particular sectors. In the 1990s, technology and telecoms stocks became a progressively larger part of the FTSE 100."

"Index and tracker funds benefited from their growth – that is until their subsequent spectacular decline. Financials then became a dominant component, and more recently mining shares featured heavily."

"In my view, the dominant, more fashionable sectors are not necessarily where you would want a large portion of your portfolio invested, as they often go on to underperform."

"I also object to the notion that any constituents of my portfolio should be dictated by size. I want to own companies with the best long-term prospects, not those that happen to be the largest at any given point in time."

Although Morgan says investors should not ignore trackers entirely, he urges them to take a closer look at actively managed funds.

"Ironically, a proliferation of ETPs, tracker funds and other passive strategies can help active managers. The more 'dumb' money there is in the market, the more anomalies there should be for active investors to exploit."

"True, many managers do not turn this to their advantage and overcome the higher fees."

"Yet a significant minority do so very effectively, and identifying them is the aim of our research," he added.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.