Bloomsbury Financial Planning

Cheap computer-run funds can now mimic the techniques of top fund managers, writes David Budworth.

Tracker funds, which mirror the performance of stock-market indexes, are adopting sophisticated strategies used by some of the world’s top professional investors in a bid to beat the markets.

A growing list of new schemes is being designed to appeal to investors who want the low costs of trackers with the glamour of active funds.

Exchange-traded funds (ETFs) are leading the way. Like conventional trackers they mirror the performance of an underlying market or index. But you can buy and sell them during the trading day on the stock market just like an ordinary share.

The first ETFs tracked key stock-market indexes such as the FTSE 100 and America’s S&P 500, but recently they have become more adventurous.

The latest have been adopting techniques such as following directors’ buying and tracking undervalued shares. These are strategies that have been used by some of Britain’s top fund managers, such as Invesco Perpetual’s Neil Woodford, to outpace the market.

Two weeks ago, Claymore Securities, an American investment firm, listed two innovative new ETFs on the American Stock Exchange.

The schemes, which charge up to 0.6 per cent compared with up to 1.5 per cent for active funds, can be bought and sold in the UK through your stockbroker.

The Claymore/Sabrient Insider index is the first ETF that invests in an index based on directors’ deals and analyst upgrades, which are regarded as a sign of greater confidence about a company’s future.

The Claymore/Sabrient Stealth index, meanwhile, follows stocks that are deemed undervalued because they are being ignored by analysts. This is one of the favourite strategies of Fidelity star fund manager Anthony Bolton. “I am not looking for the best or fastest-growing companies, but ones that have been overlooked by the market,” he has said.

Claymore claims that back-testing shows this approach would have helped you to beat the market over three, five and 10 years.

Over five years the Sabrient Stealth index has risen 23.80 per cent, compared with a 10 per cent return from the Russell 2000, a general index of shares.

But it is a risky strategy. There is a danger that stocks are out of favour for a good reason. They may take a long time to come back and could get worse before they get better.

Over one year and the first six months of this year the strategy has failed. In the first half of 2006 the Stealth index dropped 1 per cent while the Russell 2000 jumped 8 per cent.

These schemes invest only in American companies. The closest equivalent in the UK market is IShares FTSE Dividend Plus ETF managed by Barclays Global Investors (BGI).

Launched last November it offers exposure to 50 stocks that have historically paid high dividends, including Lloyds TSB, United Utilities and reinsurer Jardine Lloyd Thompson.

This mimics the approach of American fund manager Michael O’Higgins. He discovered that buying the top-yielding shares in the UK Dow Jones index and holding them for a year tended to produce better returns than the market as a whole. The ETF is up 18.9 per cent since launch, ahead of the 12 per cent rise in the FTSE All-Share.

ETFs are also branching out into more exotic areas. They provide one of the easiest and cheapest ways to invest in countries such as Taiwan, Korea, Brazil and China as well as commodities.

Axa Investment Management, in a joint venture with BNP Paribas, last year launched the first ETF to track commodity prices under the Easy ETF banner.

In September it added an agricultural commodity ETF to its range, the GS Agriculture & Livestock fund, listed on Germany’s Deutsche Borse.

Easy ETF also offers a range of funds focused on specific market sectors such as insurance, health and energy.

The schemes can be very good value for money. They have no initial charge and a typical annual management fee of less than 0.5 per cent. But you have to pay dealing charges to buy an ETF through a stockbroker, which can increase costs substantially if you trade frequently.

The risk of investing in some of the more unusual investment products should not be underestimated. Some advisers fear investors are being too clever for their own good.

“For many private investors simplicity is best. A UK investor could do worse than owning all their stock market exposure through a couple of index funds such as a FTSE All-Share and global equity tracker,” said Jason Butler of Bloomsbury Financial Planning.

Running a portfolio made up of a multitude of narrow ETFs is likely to result in poorer results for most investors because the risks of poor timing decisions are increased.”

However, as part of a balanced portfolio they can add spice to your investments.You can find out about the ETFs listed in the UK by clicking on the “Investor Centre” link on londonstockexchange.com. Recent additions are the Ishares MSCI Korea, Brazil and Taiwan.

If you can’t find what you want and your broker offers international dealing, there is nothing to stop you investing in the hundreds available in America and Europe.