Neil Woodford: Closet trackers are finally coming under threat
"While travelling around the country recently for the launch of the Income Focus fund, I have regularly been asked whether this is an appropriate time to be launching a new equity-based fund."
There is a concern that eight years after the financial crisis and with UK equities not as attractively valued as they were, the market may struggle to make further headway from here.
As an active investor, I spend a lot less time worrying about the overall market valuation than a lot of other investors and indeed market commentators do. Nevertheless, I am confident there is a very attractive opportunity from here in UK equities, in an asset class that I continue to believe is undervalued. The very fact I can build a portfolio for the Income Focus fund that should yield 5 per cent from the outset is evidence of this undervaluation.
On a price to earnings basis, the UK stockmarket trades on a mid-teens multiple, which is broadly in line with its long-term average. Not expensive as such, but nor is it particularly cheap these days either.
In the near-term, of course, there are plenty of things that could happen that could unsettle equity markets. There are a several important elections coming in Europe this year, for example, and another populist political surprise would have the potential to upset global equity markets. Although this would likely trigger volatility and some downside risk, in all likelihood it would prove short-term and temporary – serving primarily to highlight the importance of a long-term view in the equity asset class.
With that long-term view in mind, I believe the UK stockmarket can and will deliver attractive returns from here. In other words, investors that prefer passive investment strategies should do well over the long-term. As an active investor, you may be surprised to read that but, as a cheap and easy way for investors to gain exposure to a particular asset class, I believe passive investment has a role to play in the fund management industry.
Having said that, I am also a passionate believer in the benefits and importance of active fund management – I would back my funds to do considerably better than an index tracker over the long-term. The reason for this is quite simple. Even at times when markets do look overvalued, as they did at the turn of the millennium, there are pockets of undervaluation. The overall market valuation is an average of all stocks – some of which will be cheap and some will be expensive. As an active investor, it is my job to avoid the overvalued stocks and focus the portfolios towards the undervalued ones.
Put simply, this is why genuine active fund management works – it is a simple premise but that does not make it easy to accomplish. To be successful, active fund management requires discipline, conviction and a lot of hard work – but that work does pay off in the long term. Investors with an appropriate approach can and do provide consistent outperformance of the market.
As far as UK equities are concerned, investors therefore have a choice between passive and active. At one end of the spectrum you have passive, for cheap access to the potential for a good return. On the other hand, investors can choose to pay more for an actively-managed fund which offers the potential for an even better return. Two valid options, but the bulk of the fund management industry sits awkwardly in the middle of this spectrum. I believe this part of the industry is, at last, coming under threat.
Over the last couple of years, an increasing proportion of fund flows appear to be going to either passive strategies or genuinely active fund managers. The industry is becoming increasingly polarised and there is a huge chunk of the industry that will be feeling very nervous about this trend. There are a lot of funds out there that claim to be actively managed but, in reality, they are nothing of the sort – they are closet trackers, broadly tracking the performance of the market but charging investors active fees for the privilege of receiving, at best, mediocre performance.
Over the years, the practices of closet-indexation and fee obfuscation have contributed to an unfortunate erosion of trust and confidence in the active investment industry. From here, though, the future for this part of the industry looks rather bleak. With the regulator seemingly keen to ensure a clearer link between performance and charges, life is going to get even tougher for closet tracker funds and the fund management companies that offer them.
In a future world of greater transparency, there is a role to be played by passive funds and a role to be played by truly active fund managers. But the rest of the industry may struggle, and that will be a good outcome for investors.
Neil Woodford is head of investment at Woodford Investment Management