How to make an ‘Index-Plus’ fund that actually works
Most of the industry’s attempts to smooth the journey have been overpriced failures. Why? And how could this be fixed?
Asking a great active fund manager to run an “index +1%” mandate is like asking a great artist to paint a picture that’s “a bit brilliant”. This is why, I believe, these products have generally been so lousy.
What do I mean by that?
It’s because beating a market index is really hard.
As someone who tasks himself with finding the few active managers capable of doing this, my experience suggests the individuals and teams who do so emphatically are rare. They’re rare because they’re driven, by their very nature, to obsess about their way of investing, meaning they spend an unhealthy proportion of their waking hours considering how to make their returns even marginally better.
They are, in this sense, like a Picasso or a Dali. Artists who might physically assault you if you asked them to paint a picture “but just tone it down so it looks more like everything else, yeah?”.
In effect, this is what you’re asking an active manager to do with an index +1% mandate. As such, it’s a pretty good way of sorting potentially great fund managers from the uninspiring also-rans. Few managers with the obsessive drive needed to become a great would accept running a tepid, diluted version of their process, then watching as full-blooded rivals roar past them in the performance tables.
So, they end up being run by managers whose major skill is doing what they’re told. These will never be great and are not even likely to hit the seemingly modest target of beating an index by 1% a year.
Operationally speaking, what’s the difference between the two?
If an obsessive manager finds a great investment, they’ll want to hold a lot of it. If they find a dud (or even a mediocre prospect), they’ll want zero exposure. But for your typical ‘Index-Plus’ manager, if they love a stock that’s 5% of their index, they’ll put 6% in, if it’s a bit ‘meh’, they’ll hold 5%, and if they detest it, they’ll show their contempt by investing only 4% of your hard-earned money into that particular abomination.
They are, in other words, very different beasts.
None of this is to belittle the need for index +1% funds. I get why they’re necessary, although labelling them by performance rather than by their real purpose — reducing ‘tracking error’ (a measure of how much a fund’s track record differs from the market’s) — is unhelpfully misleading.
Reducing tracking error is much maligned in my proudly active corner of the industry, largely for the reasons above that imply the manager has ‘sold out’. But I take a slightly more pragmatic view.
If you were offered two funds that will outperform the market by 5% a year over a decade, but Fund A did that with a consistent 5% a year, while Fund B managed the same but with wild swings of 30% ahead one year and 20% behind the next, I think most people would take Fund A: That journey is far easier to stomach, and you’re therefore more likely to complete it (because you’re less likely to panic sell after the -20% year).
The trouble is, the only managers likely to generate any alpha, let alone 5% a year, are highly active fund managers who specialise deeply in one style of investing (maybe ‘special situations’ or ‘high growth’). And they often generate exactly the kind of +30% then -20% track record that is hard to hold. Which means too many investors ending up buying them after the +30% year, then selling after the horrors of a -20% run.
This is a good way to lose a lot of money. It’s a very common way too. This is why reducing this performance swing against the index (i.e. tracking error) is a noble goal — it should help holders to stay invested.
It’s just that it’s been done badly so far, as the industry has tended to hire sheeplike managers who aren’t capable of any alpha. So they’ve fallen short of not just their own low hurdle, but cheaper trackers too (i.e. index -0.1% funds).
What’s the answer then?
Well, here’s £500k of consulting for free: Hire an amazing, obsessive fund manager — the kind who can make 5% a year over the index — then leave them to run 20% of a fund (or ETF) in as active and unconstrained a manner as they like. Because you’re no longer asking them to compromise their style, there’ll be no storming off to launch their own boutique. They can also charge a lucrative pro-rata rate of 1% for their services (i.e. 20% of 1% = 0.2%).
Then take the other 80% of that fund and stick it in a tracker. And charge a tracker fee for that part of it (80% of 0.1% = 0.08%). You now have a fund that will make you index +1% over ten years (i.e. 20% of +5% a year), that will have a tracking error of just one fifth of the fully active equivalent, that you can scale to five times larger than that active fund, and that you can sell at a highly compelling all-in charge of just 0.28%.
You’re welcome.
This was first published in ETF Stream in April 2024. It is only my personal opinion and shouldn’t be taken as a specific recommendation or relied upon as financial advice.
