Room for passive and active funds in portfolios

they believe will perform well over the long term. The idea is that this will give better returns than a tracker fund which just holds the same stocks as the component index, say the FTSE All Share.

A closet tracker fund is one that charges like an active fund but actually holds very similar stocks to the index and also rarely trades them.

According to data from Premier Asset Management, as much as 30 per cent of funds in the UK Equity sector can be classed as closet trackers.

Other fund sectors open to UK investors, such as European equities and Global Emerging Markets, also have high levels of closet trackers.

So why does so much investor money end up in closet trackers?

The main reason is that investors in these funds are not “active” investors.

They are members of company money purchase pension schemes administered by life assurance giants. Or they once popped into their bank with a couple of thousand to invest in a PEP or ISA.

The vast majority of closet trackers are managed by life companies and high street banks. The money is very “sticky”: investors rarely switch funds let alone change provider. Without advice, they have little information on whether their investments are any good or not.

Clearly, closet tracker funds should be avoided at all costs. They charge the same as truly active funds without offering the potential benefits. The higher charges mean they can’t perform as well as a true tracker fund.

Promoters of tracker funds do like to tar all active funds with the same brush: investors are paying over the odds when it’s impossible to beat the market.

But if you take closet trackers out of the equation, the picture for active funds begins to look more attractive.

By some measures true active managers have outperformed their passive brethren. Active managers such as Neil Woodford or Nick Train have consistently outperformed the UK stock market over many years. Not every year, but they only need to outperform three years out of five to produce significantly greater returns than the index. And they are just two of a not insignificant number of active fund managers who consistently beat their benchmark.

This is not to say that there isn’t a place for passive funds within a portfolio. Some markets, particularly the US S&P 500 companies, are so well researched that it is impossible to find stock mispricing to exploit. In this market, passives have consistently out-performed actives so there is little point in paying extra fees for active management.

With any investment, it is important that the investor understands what they are buying and what they expect to achieve from it.

Closet trackers have no part in this.

A decent portfolio manager or financial adviser will easily help to avoid these. They can also access both passive and truly active funds. By carefully blending these strategies, the benefits of both can be brought to bear on an investment portfolio. Trevor Law is managing director of Merito Financial Services, chartered financial planners, based in Solihull