I want to let you into a secret.
All the best financial advice is the stuff that you already know.
It’s not sexy. It’s not going to help you get rich quick. In fact, some people would say it’s pretty obvious. And they’re probably right.
Yet that’s why this stuff works. People dismiss things that they think they already know. They think: “if it was that easy, everyone would be doing it. Tell me something I don’t know.”
But ‘knowing’ something is very different to actually practising something.
Let me give you an example.
How to boost your returns without taking more risk
Here’s a bit of ‘obvious’ investment wisdom for you. Cheap funds do better than expensive ones.
Of course they do. Logic dictates that it’s true. Most fund managers set out to beat ‘the market’. But what’s the market largely made up of? That’s right. Big institutional fund managers. Essentially, they are the market. They are buying and selling shares from each other.
The market can’t beat itself. As a result, you should only expect an average return from investing in the average fund. And if the average fund manager then takes a 1.5-2% annual fee off the top, it makes sense that on average, they will underperform.
So the closest thing to a sure thing in investment is this: the more you pay for a financial product, the more likely you are to underperform the market.
You might ask: what about the success stories? Well, you can argue that consistent successes by the likes of the Buffetts or Boltons or Woodfords of this world are the equivalent of winning lottery tickets. The odds of any single ticket winning are vanishingly small, but given enough tickets over enough time, someone is bound to win.
But we don’t need to get into that debate today. The point is, if you want to improve your chances of getting a decent return out of being in the market, then the most sensible thing you can do is reduce your costs of participating in the first place.
Investment trusts beat unit trusts because they’re cheap
In case you need convincing, the FT Money section’s front page at the weekend had more than enough evidence.
According to research group Lipper, where a fund manager runs both an investment trust and a unit trust, the investment trust version will consistently outperform, even if the portfolios are pretty similar (as they often are).
Looking at 34 fund managers over three, five and ten-year periods, investment trusts did better in 70% of cases. And the gap between the two is enough to make a real difference to your wealth. Over three years, investment trusts beat unit trusts by 7.8%. Over five years it was 9.3%, and 11.1% over ten years.
Why the outperformance? Well, some managers try to argue that it’s down to ‘gearing’. Investment trusts can borrow money to boost their returns (although this also means they can come croppers in a falling market). If you want to know more about exactly how investment trusts work, check out this video from my colleague Tim Bennett.
However, the main reason they tend do better over time seems to be down to something much simpler. It’s because investment trusts are cheaper. On average, fees are about half a percentage point lower, because they don’t have to pay commission to independent financial advisers (IFAs).
Indeed, Ed Moisson at Lipper tells the FT’s Alice Miles that if you added back the costs, then the unit trusts edged ahead over ten years. That suggests that for some managers at least, gearing might be a handicap rather than an advantage.
The lesson is simple – cut your costs
What’s the lesson? It doesn’t matter how smart the fund manager or how clever the investment strategy. You can immediately make a big difference to your future investment performance by making sure that you get into the market as cheaply as possible.
It’s an obvious point. But how many investors actually take note of it? The most recent survey by Collins Stewart showed that for the ten years to 2010, the unit trust industry had more than doubled in size. Assets under management grew from £261bn to £578bn.
You’d think that investment trusts, being the superior option, would have seen even more growth. Not a bit of it. Assets under management grew from £79bn to just £93bn.
Sure, a lot of this is down to IFAs favouring unit trusts over investment trusts because one pays commission and the other doesn’t. But that’ll all be ending soon – come the end of 2012, IFAs will no longer be able to accept commission. And in any case, it just shows how important it is that you, as an investor, understand the true cost of the funds that you are buying or are being encouraged to buy.
So if you have any unit trusts in your portfolio, do have a look at them. Check out the charges, and investigate whether there’s a less expensive way of getting the same exposure. Chances are you’ll find there’s an investment trust or perhaps even an exchange-traded fund which will do the same job for you but cheaper. And it’s a simple step that will immediately put you ahead of many of your fellow investors.
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