Richard Branson kicked off the active versus passive fund debate in 1995. When he launched his first index tracker, the bearded one told investors that most active fund managers failed to deliver at any price. His tracker fund would beat them for a fraction of the cost.
Low cost did not mean 'no cost', however. The Virgin UK Index Tracking fund promised FTSE All Share performance for 1 per cent per year, considered cheap at the time. For long term investors, even such relatively low charges proved expensive.
Over the last fifteen years to the end of September, the Virgin fund returned 164.26 per cent. The FTSE All Share index is up 221.36 per cent - a return third greater than the Virgin fund. Newer trackers, such as the Vanguard FTSE UK Equity Index, promise far less performance drag with annual charges of just 0.15 per cent.
Since markets rebounded in March 2009, the relative merits of active and passive strategies have caused headaches for fund of fund managers. Ongoing volatility makes it difficult for underlying active managers to beat markets and their own sector average returns. Twice as many IMA UK All Companies fund managers have failed to beat the FTSE All Share index than have beaten it over the last year, for example.
Under such circumstances, the sensible option would be for fund of funds (FoF) managers to opt for index trackers that deliver low beta at a lower cost than their actively managed peers. Unfortunately the charging drag of trackers pushes funds of funds further down performance tables.
Virgin, Vanguard trackers versus Global ETF Commodity & Energy sector over 3-yrs
Source: Financial Express Analytics
Relative TERs
| Fund | TER % |
| Vanguard - FTSE UK Equity Index | 0.15 |
| Virgin - UK Index Tracking | 1 |
| Lyxor ETF All Share | 0.4 |
| db x-trackers All Share | 0.4 |
Source: Financial Express Analytics
Several FoF managers think they have found the answer in ETFs. They offer a narrower tracking error over index funds, meaning their performance is far closer to that of the indices they follow. They also have no initial charges, although investors have to pay stockbroking costs. Importantly, they claim lower total expense ratios (TERs) than many traditional trackers.
Lyxor ETF and db x-trackers All Share ETFs have TERs of 0.40 per cent, beating tracker funds from M&G, L&G, Garter, Aviva, Axa and Virgin. Other ETFs are priced as low as zero.
Low costs have prompted several managers to investigate wider use of ETF products. Elliot Farley of T. Bailey says its new ETF-based Growth LITE fund uses the same asset allocation as its global growth fund of funds equivalent, the T. Bailey Growth fund, but more cheaply. The published TER of LITE fund is as low as 0.99 per cent, against 2.38 per cent for the original actively managed fund.
Farley's research shows actively managed funds of funds outperform single manager funds and trackers over the long term. Since the crash, trackers have eaten in to their lead, he said.
Other managers are taking note, picking beta plays at super low cost. Tony Lanning, head of multi manager at Gartmore, has added a gold ETF holding to his Absolute Return fund.
He said: "It's a good enough replication of the physical and importantly for us, it is nice and liquid and very cheap."
The way ETFs are built, or replicated, remains an issue. Many ETFs are 'synthetic' and use swap contracts to mirror the components of each index. Detractors say building products based on swaps causes problems if counter-parties fail, as happened to some exchange traded commodities (ETCs) when US insurer AIG collapsed.
Other ETFs are cash-based, meaning they buy the assets they replicate. Gartmore's Tony Lanning has 3.5 per cent of his portfolio in the ETF Securities Physical Gold ETF. The ETF is based on real gold bullion stored in a London vault by HSBC.