The more I think about investing, the more I wonder why we humour the financial-services industry as much as we do.
We spend far too much of our money investing in their unit trusts and far too much of our time worrying about which ones to invest in when the truth is that, whatever the marketing men may say, it doesn’t really make much difference.
Study after study shows that about 90% of our returns in the stock market come not from our special skills but from the sectors and geographical areas we end up investing in.
You can buy the best- performing fund in any given year in any given market, but the odds are that if that market as a whole performs badly the fund will still make you less money (or lose you more) than the worst-performing fund in the best-performing market.
The biggest decisions you should be making are not about which funds you should buy, but about which markets you should buy them in.
Investing in funds: how fees hit returns hard
And you’d still be best off ignoring the majority of the funds on offer in the UK.
Why? First because it is verging on the impossible to choose good funds from bad; we know for certain that the past performance of a fund is no indication of its future performance but we have little else to judge funds on.
We also know that the average fund generally returns less than the market to the investor. This is partly down to the high fees that eat away at any money they do make for you.
A £7,000 investment in a fund growing at 7% a year would be worth just over £13,500 after 10 years if there were no charges to pay. However, with normal, annual charges of 1.5% a year it would be worth less than £12,000.
Unit-trust buyers also get hit with entrance and exit fees which have a heavy impact on returns, particularly if they move in and out of funds regularly. You can cut these fees by using a fund supermarket, but even then you’ll still lose a percent or two every time you trade in and out of a fund. The annual total expense ratio for the average UK fund is still going to end up at 1.5% to 1.7%.
Investing in funds: the impact of overtrading
The other big reason why funds underperform is overtrading. Fund managers are paid to make investing decisions, so that is what they do. The problem is that they tend to make too many of them. And while that may work for some particularly clever market timers, for most it just ends in disaster.
As proof, Tim Price of Union Bancaire Privée points to a Morningstar study in June 1997, which found that funds that had shown a portfolio turnover of less than 20% saw a one-year return of 27%, those with a turnover of between 20% and 50% made 23%, those with a turnover of between 50% and 100% returned 21.8% and those that had been most active — turning over more than 100% — ended up with a return of only 17.6%.
The study is nine years old and the impact wouldn’t be so big now because the cost of trading has fallen substantially, but the point still stands: the more clever-seeming decisions the managers came up with, and the more they traded, the less money they made.
Investing in funds: choose ETFs instead
So what’s a better, cheaper and simpler way in? Exchange traded funds. I’ve looked at ETFs in this column before, but in a nutshell they are simple funds made up of set baskets of stocks (or in some cases futures contracts) that track the performance of market indexes or sectors, but shares in them trade on the stock market in the same way as any other share.
So with one call or click to your broker you can get exposure to a whole country or sector at any time during the trading day. If you think you should be invested in the UK you buy the Ishare FTSE 100 ETF, if you think Japan is the place to be (as, despite the slightly perplexing volatility we’ve seen there lately, I do) you buy the Ishare MSCI Japan, if you can’t help but think the entire world is fabulous you can go for the Ishare MSCI World, and so on.
There are more than 350 ETFs listed around the world, so if you usually invest via funds rather than in individual stocks there is really no need to use anything else.
This is not only cheap (ETFs involve no expensive fund managers and pay no commissions to advisers, so annual fees tend to run at only 0.25% to 0.5%), but the very simplicity of the strategy protects you from the incompetence of the fund-management community. It’s an altogether easier — and probably better — way to invest.
First published in The Sunday Times (23/07/2006)