Tuesday, 2 April 2013

Low Cost Index Trackers

When I started to take a serious interest in investing, the main choice would be between direct shares, unit trusts and investment trusts. I have long been aware of the importance of keeping costs to a minimum and so invested largely in shares and investment trusts.

Low cost index trackers - funds or ETFs - were not an option 20 years back however, if I were starting my investing career today, I ‘m sure these would feature quite prominently in my portfolio.

Low Cost

As I pointed out in a recent article - Avoid High Charges - to get the best returns from investments, it is important to keep costs as low as possible. Trackers do not need to research companies, they do not need to pay for star managers and there is much less portfolio turnover compared to a managed fund. Therefore the total charges for many of the lower cost trackers like Vanguard and HSBC will be around the 0.5% mark - this could easily be 2% less than many of the managed funds which are heavily advertised in the financial media when you take into account the hidden extras like portfolio turnover and soft commissions.

Index Tracker

The tracker fund or ETF tries to match the index it follows or tracks as closely as possible. There are many  trackers to cover any index you may desire - some common ones will be the FTSE 100, the FTSE All Share, the S&P 500 (USA), FTSE All World (ex UK), and Emerging Markets.

Trackers -v- Managed Funds

Over the longer periods, say 5 years +, most studies are fairly clear - the average low cost tracker will out-perform the average managed fund.

Of course, there will always be the handful of star managers who can consistently produce good returns - the likes of Neil Woodford at Perpetual or Bruce Stout at Aberdeen spring to mind - but your chances of finding such a manager at the start of your investing journey are very slim, probably less than 1 in 10.

One of the big reasons most managers fail to beat their benchmark consistently is the effect of fund charges - typically around 3% every year which is a big drag on performance - whether the manager is good, bad or indifferent, the funds all seem to charge the same ongoing charges.

So, you have maybe a 10% chance of selecting a fund that can deliver a decent return or you can choose a low cost tracker with a 100% chance of matching the index (tracking error aside).

Unless you are confident a managed fund can make a difference, for my money, most small investors will be better served over the longer term by low cost trackers.

Finally, beware of the actively managed funds that are little more than closet trackers but charge you 4 or 5 times the cost of a tracker for the privilege.

Variations in different sectors

Recent research by AWD Chase de Vere over a 10 year period shows that in almost every sector, the average fund failed to beat the index - the only sector where managed funds outperformed were smaller companies with a return of 213% over the 10 years compared to just 110% for the FTSE small cap index.

In the UK all funds sector, active funds returned 123% (after charges) compared to 132% for the all share index. In the USA, the average fund underperformed the index by 11%, in Europe 16%, Asia 45% and with emerging markets the average managed fund underperformed the index by 68%.

Patrick Connolly of AWD Chase de Vere said: "Our research shows that many investors are continuing to waste money by paying active management fees for consistent underperformance."

Charges for holding low cost trackers

With the introduction of  the Retail Distribution Review (RDR) in January, many platforms have been reviewing their charging structures. Until recently, there were usually no additional costs for holding low cost trackers in your portfolio however as many platforms have started to rebate some or all of the commissions they receive from the higher charging funds, they have started to charge customers for holding funds that pay little or no commission e.g. Vanguard.

These costs vary from broker to broker - Hargreaves Lansdown charge a flat £2 per month per holding; Sippdeal charge a flat £12.50 per quarter for as many funds as you like. Depending on the size of your investments and how many trackers you may wish to hold may determine the better broker for your particular needs. It will also vary if you want a mixture of funds, shares and ETFs for example and whether you have an ISA or SIPP.

You will need to investigate which is the most cost efficient way to invest, otherwise your savings on costs could be cancelled out by platform/broker charges.

To compare fees and brokers, check out the comparison table on Monevator.

So, low cost trackers could be a very good choice for many small investors - legendary US investor Warren Buffett says "A low-cost index tracker is going to beat a majority of the amateur-managed money or professionally managed money." - who am I to disagree!

As ever, slow & steady steps…..

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