KEY POINTS:
If ever there was a no-frills way to invest in the sharemarket it has to be tracker funds. These investments, also called passive investments or exchange traded funds (ETFs), aim to mirror the movements of sharemarket indices, such as the NZX-50, the top 50 shares on the New Zealand Stock Exchange, or the FTSE-100, the UK's top listed companies.
Tracker funds use computers to monitor companies in the index and ensure they hold a cross-section. As companies in that index grow in size, or fall out, the tracker fund adjusts its holdings to match. On the other hand, active funds employ managers whose aim is to beat an index through good research and clever stock picking.
The main advantages of tracker funds are their low costs, lower risks of a dud manager, and little serious risk of your investment underperforming the index.
Passive funds are also simple and transparent, points out Yvonne Davie, head of business at NZX's SmartShares, which runs five sharemarket-based tracker funds: smartTENZ, smartMIDZ, smartFONZ, smartMOZY, and smartOZZY.
There are other tracker funds available from the NZX or direct from fund managers such as AMP Investments' World Index Fund (WINZ) and Tower's TORTIS International Fund.
Up until now there has been a clear-cut reason why investors should favour the tracker funds over active funds. That's because they were exempt from capital gains tax. From October 1 this year active funds will be taxed in the same way as passive ones.
Some fund managers believe privately that tracker funds are dead.
Says Davie: "The people who say that tracker funds are dead because they are losing their tax advantage are my competitors. Lots of studies from overseas [say] there is a place for passive managers."
Whether tracker funds work is controversial. There are times during market cycles when you'd be best owning actively managed funds. But most private investors who hold tracker funds hold their investments for the long term and don't tend to buy and sell.
Binu Paul, general manager of investment research house FundSource, says: "In down markets, passive tracker funds perform better and active funds do better in upward markets." The reason for this is that the active managers take big punts on investments that they believe will perform better than average and as a result they beat the index.
The Fisher Funds NZ Growth Fund, for example, which is managed very actively, had a return of 33.26 per cent before tax and fees over the past year and 18.75 per cent per annum over five years. That compared with 27.69 per cent for NZX's passive SmartMIDZ fund over one year and 14.215 per cent over five years.
Even with the taxation of both investments equalised, there is another wild card to include and that's fees, which can eat into the long-term growth of an investment. Upfront fees on tracker funds are usually fairly low or non-existent. With active funds, up to 6 per cent entry fee is taken out of your money even before it's invested.
Tracker funds are often less volatile and the spread between the share or unit price and the net asset value of the holdings tends to be closer than actively managed funds.
There is a definite air in the financial community that tracker funds will have seen their day once active funds are on the same level taxation playing field. The assumption is that the only reason to buy trackers was that they grew faster because investors paid less tax. It is true to say that this is how they were often marketed.
Having said that, says fee-based financial planner Simon Hassan of Hassan & Associates, there is still a place at the core of a portfolio for an investor to have a tracker fund if they want to replicate an index.
Tracker funds are immensely popular in countries such as the United States and the UK in their own right. In many ways, says Hassan, an investment in the S&P500 or FTSE-100 is much more meaningful than an NZX tracker, which includes far fewer and much smaller companies.
Ultimately, the return isn't the only reason to make an investment decision. Tracker funds are a quick and easy way to diversify a portfolio. Even SmartShares' Davie says she uses tracker funds as the core of her investment portfolio and buys shares in individual companies as well. Some investors prefer actively managed funds in that secondary role.
It's necessary when choosing a tracker fund to know what you're buying into. The WINZ fund, for example, follows a variation of the MSCI world index, concentrating on a list of countries that had tax advantages in the past for Kiwi investors.
Overseas there are tracker funds covering all manner of indices as specific as sectors or sections of overseas markets. Here there are few and they're vanilla flavoured. What that means is that if you want investments in bonds, commercial property, commodities, or a fund that has an element of hedging against a falling market, then you're out in the cold.
Although fund managers are celebrating the tax changes, they are going to have to do more to prove that they are adding value, says Paul. That's because it's now much easier to compare apples with apples and if the managers can't outperform the passive funds after fees have been deducted, then investors would be forgiven for asking questions about what they're paying for.
Research shows that tracker funds often outperform actively managed funds run by star managers in the long run although the latter may have some excellent individual years or streaks of good luck along the way.
Princeton University economics professor Burton Malkiel argues that markets price stocks so efficiently that a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio that performs as well as those managed by the experts.
It is also a little known fact that financial institutions from around the world who want exposure to an overseas market will often put their money in tracker funds rather than do individual stock picking from afar, says Davie.
AMP Capital Investors head of investment strategy Leo Krippner says that managers can and do beat the index and investors are better off even once they've paid the higher fees associated with active management. "We think we can add 1.5 per cent to 2 per cent a year, which is well in excess of the additional fees."
The investors who are best suited to tracker funds are those who want to have a stake in sharemarket-listed companies, but can't take the volatility, says Paul.
Davie goes on to say that although many of SmartShares' investors are new to the game, increasingly older investors who either don't want to monitor the market or have failed at picking their own shares in the past are buying into the funds.
One useful feature of the SmartShares funds is that once you've bought an initial chunk of shares there is a regular savings facility that allows investors to save as little as $50 a month into the fund, instilling a regular savings mentality and smoothing out the cost per share over time.
