Trackers: winning the long game
An FT letter writer recently described tracking a stockmarket index as ‘a race in which the athletes absurdly strive for an average performance’. This is a common misconception, arising from extrapolating short-period relative returns (where the description fits) to long periods. In fact, at some time horizon the lowest-cost trackers are bound to achieve significantly better returns than the average actively managed fund.
The relative positions over a long race depend on i) the cost difference compared with most active funds and ii) the typical size of the bets against the index made by active managers. Based on historic return data and current cost differences for UK equity unit trusts, the decile rank of the cheapest tracker is likely to be 3rd over about 15 years and after 20 years they may even be in the top 20%.
Trackers will never win the race outright. Some active funds will beat them over any long period and there will also be some dynamic strategies for selecting and trading active funds that win enough of the shorter-period races to beat them. However, the margin by which both sorts of outright winners can be expected to beat the lowest-cost trackers is strikingly small considering there is only an outside chance of identifying them successfully before the event.
That outside chance with hindsight should also allow, before the event, for the high probability that at some stage over the course of the race the eventual outright winners will have looked indistinguishable from losers. This arises because of the inevitable inconsistency in the payoffs for the individual bets the best managers make. The practical impact is that few investors stick with the eventual winners through thick and thin.
In such a race, the public’s preference for an active gamble over a near certainty is likely to reflect widespread ignorance of i) the costs of playing ii) the chances of winning and iii) the path and eventual size of payoffs. For investment managers, their customers’ ignorance is bliss. Better informed, they would need a tiny fraction of the number of fund managers and products. Even advice would be less necessary.
Amongst well-informed investors, the desire for an active gamble may also persist to satisfy a human instinct to try, rather than a true expectation of winning. In this case, however, the core equity position is still likely to be in trackers.