Index tracking has failed UK stock market investors

Put simply, the value of the UK stock market – as measured by the FTSE All-Share Index – has been too concentrated in very big companies that have very poor growth prospects and in many cases are declining or expected to do so. Big oil companies, banks and insurance companies are good examples of this and their poor share price performances over the past decade has reflected their deteriorating prospects..

Unlike the US market, the UK market contains few giant global leaders that have been able to drive the value of it higher. Yet outstanding businesses do exist in many medium and smaller-sized companies.

However, what is undeniably true is that an investor buying the UK stock market has not had a great time, not just this year but over the long haul as well. The FTSE All-Share has delivered total returns of 64 per cent over the past decade. Over the past 20 years, total returns have been 118 per cent, which equates to a compound average growth rate of just under 4 per cent. Over the same period, inflation as measured by the retail price index has averaged 2.7 per cent a year. So a basket of UK shares has done a job of increasing the buying power of an investor’s savings, but only just.

America’s stock market has performed much better and is up by 245 per cent over 20 years, or an average annual growth rate of 6.4 per cent. In the past 10 years it has trounced the UK, growing at an average annual rate of 13.7 per cent against the FTSE All-Share’s meagre 5.1 per cent.

It has done so for the very simple reason that it contains better companies with better growth prospects. Whether these companies have become overvalued or not is another matter, which I will come back to.

2020 year to date total returns and average annual total returns

Source: FactSet

A better experience has come from investing in the FTSE 250 index, but this has not prevented it from being on the end of a real battering in 2020 given the shares of the companies in it have a high exposure to a fragile UK economy.

Tracking the UK stock market is a bad idea

However, the key point that I want to get across here is that the professional UK investing community continues to benchmark itself against an index that in itself has been very bad at making investors a reasonable amount of money compared to the risks that they are taking on.

There should be no doubt that any fund manager worth their salt should be aiming to beat an index as unattractive as the FTSE All-Share. 

One of the key sales pitches of active fund managers is that their stockpicking prowess will allow them to outperform in a bear market. Well, 2020 has been such a time when active managers should have proved their worth, but this doesn’t seem to have been the case for many of them.

I have taken a sample of 89 actively managed UK equity funds in the UK All Companies sector and looked at the distribution of their returns so far in 2020.

None of these institutional funds has delivered a positive total return against an All-Share Index that has fallen by 19.7 per cent. However, what you can see is a clustering of returns of actively managed UK funds very close to the returns of the market as a whole.

I take on board the view that this should not be a total surprise as collectively these investors are the market. That said, the results seem to show that the process of closet tracking – where a fund manager’s portfolio looks very similar to the make-up of the index they are trying to beat – may be alive and well.

This is not the fault of the individual fund managers running these funds, but more of the industry they work in. There are still too many companies that prioritise scale and the income and profitability that comes from it instead of being genuinely active stockpickers looking to beat the market.

Fund management is a very lucrative business with mainly fixed costs. Charging 0.75 per cent a year on a big pot of money can add up to very large profits once those fixed costs have been paid. The big risk to those profits comes from losing an investment mandate from a customer, which usually comes from underperforming the benchmark index.

So instead of trying to deliver the highest risk-adjusted returns for their customers, the temptation is to focus on not losing customers instead and to maintain the lucrative economics of the fund management industry. The most conventional way of doing this is to put together a portfolio that aims to beat the index by just a little bit if things go well and to underperform by a little bit – not enough so that the customer takes its money elsewhere – if things don’t work out as expected.

What this means in practice is that the UK fund manager has often been found to be owning lots of shares that they don’t really like because it is in their best interests not to stray far from the index. Should they try to put together a portfolio that is radically different from the benchmark index it is not unheard of for them to be told by their employer that they are taking too much risk (in jargon their 'tracking error'). 

If they do and the portfolio underperforms then they might even lose their job as the fear of losing customers increases. This is what was seen during the tech boom in the late 1990s when managers who refused to own massively overvalued stocks lost their jobs even though they had put together a genuinely active fund that in many cases would have delivered better longer-term returns to patient investors.

This conflicted industry structure explains a great deal as to why active fund management has got such a bad name. The prevalence of closet trackers is rightly called out as a rip-off.

However, I think that the view that active managers cannot outperform the market, charge too much for trying and that investors are better off buying index-tracking funds is overly simplistic and not clear cut.

Fees for active funds are arguably still too high in some cases. That said, the evidence that cheap index-tracking funds – perhaps with the exception of the FTSE 250 – are the answer is pretty weak in my view.

The case for active fund management is strong if done the right way

The unattractive option of owning the FTSE All-Share index in a tracker fund or an active fund that looks too much like it means that the UK market is the perfect backdrop for active stockpickers.

Picking winning stocks is not easy, but there are fund managers out there who have developed strategies that have decent long-term track records. 

While not applicable to all successful UK funds, many of them have performed well by running concentrated stock portfolios (40 stocks or fewer) and taking sizeable positions in quality growth companies. The foundations of these portfolios are based around intense research into company business models and selecting strong and growing ones. This, in turn, has been a great way of reducing the business risk of their portfolios.

These funds represent genuine active management in my view where the fund managers can rightly claim to have portfolios that are radically different from the make-up of the FTSE All-Share Index and with a performance to match. 

The funds listed below show the success of their stockpicking over the past five years. All have substantially outperformed the FTSE All-Share index, which has delivered total returns of just 18.9 per cent over the period. They have also been much more resilient in this year’s sell-off.

Examples of successful active management in UK shares

Source: SharePad/Investors Chronicle

As you can see, many of the funds are adopting a concentrated approach either by having a relatively small portfolio of stock and/or a high concentration of the portfolio in the 10 biggest positions (Chelverton UK Equity Growth is the main outlier here).

This means that if their stock picks are right they can outperform the market in a significant way. They also protect themselves from the potential problem of what Peter Lynch used to call “diworsification” – where owning too many stocks diluted the potential returns of a portfolio.

Of course there is the risk that they get it wrong and massively underperform. However, it is the conviction to take a genuine active approach that the customer is paying for. They need to be comfortable that their investment approach is the right one and above all understandable.

There is no reason why the private investor cannot have similar levels of success by running concentrated portfolios as well. In fact, if they are to understand individual companies and stocks properly, it is difficult to own and manage a portfolio of more than 15-20 stocks well. They may wish to consider complementing this with some funds 

The same rules apply. They must take the time and effort to understand the business they are investing in and its risks, with particular emphasis on how it performs when an economy or industry turns down. They should also be mindful not to overpay for a rosy outlook, but as I’ve written recently they should not obsess about valuation or be scared of paying what looks like a high price.

The future of the UK stock market

The dire performance of the UK market both in recent times and over the past 20 years has been very sobering. It has led to some now seeing it as being overlooked, undervalued and even downright cheap.

I’m not too sure that’s the case. The fundamental growth outlook for companies that make up a large chunk of the market look tough, which means that the valuation of it may not be unkind. Many struggling companies look like classic value traps.

The big unknown is whether the stellar outperformance of quality growth stocks can continue as their valuations are looking stretched even when low bond yields and low inflation are factored in.

Value investors will hope for some kind of catalyst to bring them some cheer. An increase in takeover activity might be such an event. The recent bid battle for William Hill (WMH) suggests this is possible, but it’s difficult to see what will make the UK market an attractive market for investors to track anytime soon.