Brad Barber and Terrance Odean, two California-based economists, have shown a reason for our enthusiasm for trackers. They've found that most retail investors around the world underperform the market; they'd be better off in tracker funds. And researchers at Vanguard - admittedly not a neutral source - have shown that most actively managed funds also underperform their benchmark indices*.
This poses the question: why don’t more investors simply leave their money in tracker funds? There are two reasonable answers.
One is that it is possible - in theory - to beat the market. There’s good evidence that three strategies at least enable us to do so: investments in momentum, defensives and quality stocks (those with high and growing profits and good payout ratios). Fund managers can't follow such strategies because they carry benchmark risk - the danger of underperforming a rising market for a while and so getting the manager the sack.
However, this doesn't guarantee that retail investors can do better than tracker funds; most of them lack the discipline to stick to such simple successful strategies over the long-term.
There's a second reason why some investors avoid trackers. Investing in them gives us big exposure to a handful of companies; the 10 biggest UK stocks account for just under one third of the market capitalisation of the All-Share index. This means that a tracker fund is, in effect, a bet upon the fortunes of a few mega-cap shares. If these do badly, tracker funds will underperform many active investment strategies simply because most equal-weighted baskets of stocks will beat a capitalisation-weighted index.
This is no mere theoretical possibility. It's just what’s happened in the last three years. During this time, many mega-cap stocks - such as BG, Anglo American, Rio Tinto, Tesco and HSBC - have done badly while small caps have generally done well. As a result, All-Share trackers have done relatively badly. For example, Legal & General’s UK index fund has come 184th out of 279 funds in Trustnet’s database of all companies funds in the last three years, while Scottish Widows All-Share tracker has come 205th - to take two funds owned by your correspondent.
However, there’s a big piece of economic theory which tells us that this experience is anomalous. It’s Gibrat’s law. This says that, in the long-run, corporate growth should be independent of size, so big firms should grow at the same rate as small ones, suggesting that equity returns should be similar.
Studies of individual firms corroborate this. Alex Coad of the Max Planck Institute found that although very small firms - those too small to be in the All-Share index - tend to grow faster than average, Gibrat’s law is "a useful first approximation". In the long-run, therefore, the exposure to mega-caps which tracker funds give us shouldn’t hurt us much.
Which raises the question: why hasn’t this been true recently? We can use the performance of our benchmark mega-cap portfolio (an equal-weighted basket of the 20 biggest shares) to answer this. Looking for correlations between its annual returns relative to the All-Share index since we began it in 2004 and other factors can tell us when mega-caps are likely to do well, and hence when tracker funds might beat active funds. This exercise reveals that mega-caps and hence trackers do well in the following circumstances:
■ When low-yield stocks outperform higher yield ones. Mega-caps are a little more like growth stocks than value ones.
■ When Aim stocks underperform. When investors’ sentiment improves, Aim does well. But this is also likely to be a time when small caps generally do relatively well, to the detriment of mega-caps and trackers.
■ When commodity prices rise. Mega-caps have traditionally had a bias towards resource stocks.
There’s also a relationship between mega-caps and interest rates. Mega caps do relatively well when the gilt yield curve steepens - when 10-year yields rise relative to two-year ones. But they also do relatively well when three-month rates rise relative to two-year ones. This is probably because mega-caps are less dependent upon UK bank finance and less sensitive to domestic economic conditions than smaller firms.
These factors together can explain three-quarters of the variation in annual returns on mega-caps relative to the All-Share index. Sadly, though, they are largely unpredictable. Sure, it’s a safeish bet that the next move in short-term rates will be up, which should be relatively good for mega-caps and trackers. But fluctuations in investors’ sentiment and in growth stocks relative to value contain a big random element. This implies that, to a large extent, we can’t predict when trackers will do well or badly relative to active funds.
But tracker funds aren’t supposed to be merely short-term investments. They’re for the long-term. And while the long-term is of course largely unpredictable, there are two things we do know - that funds' charges compound nastily over time; and that Gibrat's law isn't too far from the truth. For me personally, these facts - along with my laziness - argue for sticking with trackers.
* It’s perfectly possible for most people to underperform the market, if they have slight underperformance while the minority of outperformers have big outperformance.
