Exchange-traded funds run rings around many fund managers

Here's a bold proposal: two out of three fund managers should be fired. They should lose their jobs, forthwith. And who should replace them? That's easy. Computers.

Why so harsh? Because an astonishing two out of three fund managers failed to beat their benchmark last year. The research, from Citywire, a London-based financial services publisher, shows that only one in three managers added value in 2011. The rest failed to justify their hefty charges.

The research covered 1,800 active funds across a range of asset classes, including equities, bonds, property and commodities. Year after year, just one in three fund managers justify their existence by beating their benchmark index. Last year was a particularly bad year, but it wasn't that unusual.

This research appears to boost the arguments in favour of investing in low-cost "passive" index-tracking mutual funds and hugely popular exchange-traded funds (ETFs). Instead of paying a fund manager a handsome salary to outperform the index, they passively track the performance of a chosen index.

Citywire's research suggests that two times out of three, they will come out on top. You will also save a small fortune in fees.

Now two out of three ain't bad, so should you ditch your overpriced, actively managed mutual funds and embrace cut-price trackers instead? Or is the decision more complicated than it seems?

The passive versus active debate has been raging for years and will never be fully resolved either way. But lately, the balance has swung in favour of trackers thanks to the explosive popularity of ETFs: passive, low-cost investment funds that are traded like shares.

State Street Global Advisers launched the first ETF in 1993, tracking the S&P 500. Trustnetoffshore.com now lists nearly 2,500 ETFs from 63 investment groups, including Barclays Capital, BlackRock, DB Platinum Advisers, ETF Securities, Invesco PowerShare, iShares and US ProShares. Gold ETFs have been particularly popular lately. If you want to track, you won't be short of choice.

ETFs offer a number of advantages over traditional mutual funds, says David Gardner, the head of sales for iShares EMEA, which offers 460 global ETFs traded on 19 exchanges worldwide.

"ETFs give investors access to markets and asset classes in a precise and cost-efficient way, so you know exactly which markets, stocks, bonds or commodities you are invested in at any time," Mr Gardner says. "They also offer intra-day pricing, which means you can see the value of your holdings continuously and take investment decisions based on this information."

By contrast, many mutual funds are priced just once a day. If you sell or buy during a spell of volatility, you can't be certain what price the deal will be executed at. "ETFs can help you take advantage of tactical opportunities because you can buy them quickly, cheaply and efficiently."

Mr Gardner says its investors use ETFs as a building block to establish their core portfolio holdings. "They often combine ETFs with a selection of active funds, which have consistently outperformed their index."

For most investors, a portfolio of passive ETFs is the best option, says Peter Barr, a senior investment analyst at the Dubai-based Holborn Group, a financial services company.

"The cost savings alone are likely to result in significant outperformance against a portfolio of actively managed funds," Mr Barr says.

Many investors don't realise how much of a drag fund charges can inflict on performance. Say you invest a lump sum of US$10,000 (Dh36,732) in an active fund with a typical initial charge of 5 per cent and an annual management fee of 1.5 per cent.

That initial charge immediately swallows $500 of your money. So you only actually invest $9,500. But it's the smaller 1.5 per cent annual management fee that does most of the damage because you pay it year after year.

If the fund grows at 6 per cent a year, your fund will be worth $14,753 after 10 years, after charges. That doesn't sound bad, until you compare it with ETFs.

The average ETF has no initial charge and an annual fee of about 0.5 per cent. If you invested $10,000 and it grew at the same 6 per cent a year, you would have $17,081 after 10 years. That's an extra $2,328.

The difference becomes more marked over time. Over 20 years, you would have $22,911 in the mutual fund, assuming 6 per cent growth, but $29,178 in the ETF. That's $6,267 more.

Charges aren't everything, Mr Barr says. "Some actively managed funds perform very well. The trouble is that identifying those funds ahead of time is extremely difficult. Historical data tells us that past performance doesn't correlate with future performance. Simply picking the best-performing funds from previous years is unlikely to be a good strategy," he says.

This doesn't mean you should always prefer an ETF. Your decision partly depends on the sector or market you are investing in. "Fund managers investing in global bonds have the worst record of beating their benchmarks," Mr Barr says. "Funds investing in developed western markets also struggle. If you are choosing between an ETF tracking the UK FTSE 100 and an actively managed fund investing in large cap UK stocks, the ETF has the edge."

Yet active managers specialising in smaller companies, emerging markets and Japan have a much better record of beating their benchmarks. "You should lean towards actively managed funds in these sectors," Mr Barr says.

Trackers and ETFs aren't exactly perfect either.

The first problem is that you will never, ever beat the market. In fact, if you take out a tracker, you are buying guaranteed underperformance, says Rob Worthington, an academy sales manager at JP Morgan Asset Management, the fund manager. "Trackers charge an annual fee of between 0.3 per cent and 1.55 per cent a year and this comes from your returns. You will always get less than the index, after charges have been deducted. Whereas the best managers can beat the market, trackers will always underperform."

Another problem is that some ETFs don't actually invest in the physical products they are tracking. Instead of actually buying the components of an index, so-called "synthetic" ETFs give your cash to an investment bank, a "counterparty", which promises to match the return on that index.

The banks usually do this by using complex derivative swap contracts. "Investment banks are under a lot of pressure at the moment. If something happens to the counterparty bank, your money is at risk. This is a risk you simply can't measure and probably don't want to take," Mr Worthington says.

Many synthetic ETFs also have a tracking error, which tends to get worse over time and may eventually lead to serious underperformance. So if you are buying an ETF, you need to make your choice very carefully.

Mr Worthington points out that trackers only follow the fortunes of companies once they have entered the index. "An ETF will never catch the next Apple at an early stage, it will only invest in it once it has grown large enough to hit the index."

Index tracking can be particularly dangerous in emerging markets such as China, where corporate governance is still a problem. "If you buy a tracker, you are buying good and bad companies. If you invest with a fund manager, they have to carry out due diligence on any stocks they invest in. You pay higher charges for that, but we believe that is a price worth paying. One of our managers recently visited China to see a large paper milling company. It looked a great prospect, until he checked out one of the company's forests. It was a car park. A passive fund would have invested in that car park," Mr Worthington says.

The big problem with fund managers is that some underperform year after year, often for a decade or more, says Mark Dampier, the head of research at Hargreaves Lansdown, the UK's largest independent financial advisers. "There aren't that many talented fund managers. That's what drags down the overall performance figures for actively managed funds. Yet people leave billions of dollars sitting in these funds getting a lousy return. Why they stick with these funds beats me, but they do, and that makes fund managers look bad generally."

You need to seek out managers with a proven track record of outperformance, year after year. "Even a good fund manager won't beat the index every year, but over five or 10 years, they should come out comfortably on top. Look for a fund investing in a sector or theme that you understand, with clear aims and strong management. That should give you a good chance of picking a winner," Mr Dampier says.

The daft thing about mutual funds is that the bad ones charge exactly the same as the good ones. "With most products, you pay more for quality. That's not the case with funds. This is something the industry should address."

Consumers should shoulder some of the blame, Mr Dampier says. "They are too willing to put up with bad performance and high fees. They should vote with their feet and move on."

Two out of three fund managers won't be fired and replaced with a computer. Instead, most will be rewarded with fat bonuses. But you can fire the underperformers - from your portfolio.

Hang onto the winners, though.

pf@thenational.ae

Nine EFTs

Gold

SPDR Gold Shares Trust (GLD)

US large cap stocks

SPDR S&P 500 (SPY)

Emerging market stocks

iShares MSCI Emerging Index Fund (EEM)

Commodities

iShares S&P GSCI Commodity ETF (GSG)

European stocks

iShares S&P Europe 350 (IEV)

US bonds

Vanguard Total Bond Market ETF (BND)

Japan stocks

iShares MSCI Japan ETF (EWJ)

Asia stocks

iShares MSCI Pacific ex-Japan (EPP)

UK stocks

iShares FTSE 100 (ISF.L)

Source: Peter Barr, Holborn Group