Wednesday, 20 July 2016

Low Cost Index Funds - Updated

Over the past few weeks, I have been reviewing some of my earlier posts in the ‘basics’ section of the blog. Many were written in 2013 and may therefore need to be updated and expanded. This week I will take the opportunity to have another look at index funds.

For the greater part of my investing journey, I have used a combination of individual shares and investment trusts. However, I did hold a FTSE all share index PEP directly with Legal & General as far back as 1995 following some research supporting the benefits of low cost investing.

I have long been aware of the importance of keeping costs to a minimum and so my investing strategy in the earlier years was largely via the lower cost options of individual shares and investment trusts rather than the traditional unit trust funds.

More recently, I have returned more of my portfolio toward index funds following a review of strategy in early 2015.

Low Cost

As investors, we cannot control the direction of the markets but we do have a big say in what we pay for our investments and the platform we select to hold them. There is a wide choice of investment funds and trusts - some are relatively expensive, others are very low cost.

The more expensive funds are generally managed and offer to provide a better return than the market. The least expensive funds are nearly all index trackers which offer to match the index (before costs).

To get the best returns from investments it will therefore be necessary to either pay for the higher charging managed funds which can consistently out-perform the market over the longer periods or settle for holding index funds which aim to match the market in order to keep costs as low as possible.

What you certainly want to avoid is expensive managed funds which underperform the market.

One of the big reasons most managers fail to beat their benchmark consistently is the effect of fund charges - depending upon the rate of portfolio turnover which involve transaction costs - typically around 2% or even 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).

As Charlie Munger pointed out, Berkshire Hathaway shareholders have been well rewarded over the company's investment journey. There will always be a small set of managers who will outperform market returns. The challenge is finding them, and that, as Munger told the annual meeting, 'is like trying to find a needle in a haystack.'

Better, then, to buy the haystack!

Unless you are confident a managed fund can make a difference and add value for the additional charges, for my money, most small investors will be better served over the longer term by low cost index funds.

Also, beware of the actively managed funds that are little more than closet trackers but charge you up to 15x the cost of a tracker for the privilege.

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 the average managed fund. Therefore the total charges for many of the lower cost trackers from the likes of Vanguard and BlackRock will generally be below the 0.25% mark - this could easily be 1% less than many of the managed funds which are heavily advertised in the financial media when you take into account the hidden extra costs such as portfolio turnover transaction costs which are not included in the headline ongoing charges and which could easily add an additional 0.5% to the total cost of ownership.

Index Tracker

Passive investing in tracker funds or ETFs will simply track a market, and charges will be far less in comparison. The funds are essentially run by computer and will buy all of the assets in a particular index, or the majority, to give you a return that reflects how the market is performing.

The index fund 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.

Passive Index -v- Actively Managed Funds

A passive approach frees investors from the task of fund selection and eliminates manager risk. This means that basically their returns will be largely determined by asset allocation combined with the costs of the fund selected to track the required sector of the market.

As Tim Hale points out in ‘Smarter Investing’ - we all like to think we are a better than average driver, but not everyone can be better than average. Human nature drives us to compete with others, to succeed, and to be better than average. Investors try to get a better than average return and often select funds which promise to provide this.

However, the markets are very efficient. All the empirical evidence over decades shows that beating the market consistently after costs through skill is very difficult. The fund managers who can do this are rare and are very difficult to identify in advance.

It is a mathematical certainty that the market will beat the average fund manager after costs.

The Nobel Prize-winning economist William Sharp explained in his 1991 paper, "The Arithmetic of Active Management", the investing community is divided into two — active investors and passive investors.

Before costs, the return on the average actively managed pound will equal the return on the average passively managed pound. After costs, however, the return on the average actively managed pound must be less than the return on the average passively managed pound. Therefore, the average active investor must - no ifs, buts or maybes - underperform the average passive investor.

This isn’t a theory; it’s mathematical fact. To quote Professor Sharpe: “These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”

Of course, over 1, 2 or even 3 years a fair proportion of managed funds will out-perform the benchmark index - some of this will be down to the skill of the manager allocating his/her portfolio towards the right sectors or avoiding the underperforming sectors. But some will be just the product of pure luck.

However, luck will run out eventually and over the longer periods, say 5 years +, most studies are fairly clear - more 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 immediately springs to mind, Nick Train of Finsbury Growth & Income trust is another - however it takes several years for a new manager to build a track record and then, for the average punter, your chances of finding such a manager at the start of your investing journey are very slim.

To quote The Pensions Institute, which has conducted one of the most comprehensive studies of UK funds in recent years, the vast majority of UK fund managers are “genuinely unskilled”, and even those very few managers who do beat the market consistently “extract the whole of this superior performance for themselves via their fees, leaving nothing for investors”.

(Thanks to TEBI for the above links)

According to a recent study from Dalbar, (summarised here) the average small investor has not done so well over the 20 yr period to 2015. Their annualised average return was just 2.1% p.a. compared to 8.2% p.a. from equities and 5.3% p.a. from bonds. These studies are based on the US market but there is no reason to think the figures would be much different in the UK.

This 6% difference each year, possibly 5.5% taking costs into account, between what the investor could have achieved from the market compared to what the average investor actually achieved is called the ‘behaviour gap’.

A big reason why individuals underperform the market is the simple fact that we are human and have emotions - greed, fear - and Mr Market is an expert in exploiting our anxieties. It not easy to stay the course over 10, 20 or 30 years - not only do you have volatile markets but you also have the emotional and irrational you which manifests itself in many ways - chopping and changing your plans, chasing last years best performing fund/sector, buying high and selling low...

Here’s a useful graphic (pdf) from BlackRock which illustrates the point.

Charlie Ellis ‘Winning the Loser’s Game
"The hardest work in investing is not intellectual, its emotional. Being rational in an emotional environment is not easy. The hardest work is not figuring out the best investment policy; its sustaining a long term focus at market highs or market lows and remaining committed to a sound investment policy. Its hard especially when Mr Market always tries to trick you into making changes".

Local or Global

Many small investors in the UK will usually hold mainly investments listed on the London exchange - typically shares, funds or investment trusts.

However, the UK market makes up less than 10% of the global market. Why limit your investments to a small sector of the global marketplace when it is just as easy to purchase the whole market?

Of course we all feel more comfortable with what is familiar and many small investors believe they understand their home market.

They are also afraid of currency exchange fluctuations. For example, following the unexpected Brexit referendum result in June, the value of sterling fell dramatically by ~ 12% in just 48 hours.

Most investors understand the principle of reducing risk by diversifying. Holding 20 shares spreads the risk compared to holding 2 or 3 shares. Likewise holding and investment trust or fund which may hold over 100 shares reduces risk even further.

The next logical step would be to hold shares from many different markets all around the globe rather than hold all your eggs in one basket - the UK.

As a general rule, for me, the lower cost funds - active or passive, will usually provide the better returns compared to the higher cost funds over time. For a simple, no frills buy-and-forget approach, I believe most investors will benefit from a low cost, globally diverse and balanced index fund.

Platform Charges for holding low cost trackers

One final consideration is the question of where to hold your low cost tracker fund. To some extent, it will be counter productive to focus on low fund costs unless you also aim for low platform costs - these two elements should be considered in tandem.

It can be a little confusing trying to work out the most cost effective way to construct your passive portfolio. Some brokers charge an annual percentage fee based on the value of your holdings and others charge a set fee regardless of how much you may have invested.

The charges for holding ETFs may differ from the charges for holding funds. With some brokers there is no charge for dealing in funds which is good if you are building your portfolio via monthly subscriptions rather than a one-off lump sum.

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.

I have covered many of these aspects in my article ‘Selecting Your Online DIY Broker’. You can cross reference your selections using the excellent 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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