Enhanced index funds: the best of both worlds?

It therefore wasn’t a surprise to the fund industry and adviser community when investment heavyweights JPMorgan Asset Management and Schroder announced the launch of ‘enhanced index’ funds.

May 2011 saw the funds out in the marketplace, although the JPMorgan product was already in existence under another guise.

But have these ‘cheap alpha’ funds really filled a gap in what is already a crowded marketplace?

Martin Bamford, managing director and chartered financial planner at Informed Choice, says: “These hybrids between active and tracker funds have failed to gain traction with investors, in spite of being an interesting innovation. Most investors will either select tracker funds or actively managed funds, with some creating a portfolio blending the two.

“In practice, many tracker funds offer an element of these active decisions, as investors still need to make an active decision about which market they track and the replication method. There is no such thing as truly passive investing, as active decisions need to be made at every turn.”

In April, passive fund specialist Vanguard produced a white paper that looked into the performance of active funds and found that, in almost all areas, fewer than half the funds analysed beat the index. This was more extreme when considering funds that were wound up or merged.

Commenting on the findings in the white paper, Hargreaves Lansdown investment manager Adam Laird explains: “This study is further evidence of an unfortunate truth – many active managers disappoint. There are some areas where it is very difficult for investors to find a good fund manager, such as US equities where many of the best funds are closed to new investment. The report highlights the importance of thorough research in finding good managers in sectors like UK Smaller Companies, where many have performed well.

“We have seen a lot of interest in the past few years from investors in passive funds. More than 11 per cent of Vantage clients hold tracker funds or exchange-traded funds (ETFs) in their portfolios. We see funds being used as core investments and ETFs being used to access more specific areas, like commodities or individual countries.”

However, Mr Laird admits that active and passive are not incompatible. “If a client holds tracker funds, on average they are only 20 per cent of the portfolio. Holding a tracker removes the risk that your fund will substantially disappoint – it should perform the same as the index less charges.”

Darius McDermott, managing director at Chelsea Financial Services, says that, in theory, ‘enhanced index’ funds are attractive investment vehicles for retail investors.

“They are cheap and, as many people are keen to point out, only 30 per cent of fully actively managed funds outperform the market on a consistent basis, so why not get a tracker with a bit of alpha on the side, which these funds essentially are?

“But there is little evidence to show this type of strategy is working, as performance has been mediocre at best and they have attracted little in the way of assets. Indeed, some companies have shelved or delayed any plans to increase their range of these funds as demand just isn’t there.”

But this hasn’t put Mr Bamford off the concept behind low-cost active funds. He confirms: “I would like to see more low-cost active funds in the UK market, although I suspect with the widespread adoption of ‘clean funds’ we will see the reduction in active fund management charges from the current 0.6-0.75 per cent level to something closer to the annual management charges levied by the likes of JPMorgan and Schroders.”

For Mr McDermott, investors would be better off sticking with a combination of active and passive funds within a portfolio.

“Essentially, I think it is probably best to pick a true tracker or a true actively managed fund rather than trying to combine the two – instead of getting the best of both worlds you are getting the worst.”

Jenny Lowe is features editor at Investment Adviser

Going passive – the checklist

1 It is important to check what investments a fund holds

2 How is the vehicle structured? If you need the flexibility, an ETF may be better than a mutual fund

3 You need to consider the initial and annual costs of investing