Why pay a fortune for an investment manager when unit trusts rarely beat a stock market's performance? Opt instead for cheaper, more user-friendly index funds, says David Prosser.
Warren Buffet, the world's second richest man, has amassed over $15 billion from stock market investments. Others are blessed with neither his talents nor his luck. That's why many of us allow investment managers to look after our money.
However, these professionals are hardly repaying our faith in their expertise.
Over a five-year period, about 80% of unit trusts fail to beat the performance of the stock market in which they are investing.
If this is so, why on earth bother paying a fund manager to try and outdo stock markets, particularly when unit trust charges - typically an initial charge of 5% of your investment and then an annual management fee of 1.5% of your fund - are so steep?
With this question in mind, a small but growing minority of investors are turning to indexed funds. According to the Association of Unit Trusts and Investment Funds, the unit trust trade body, well over 2% of UK unit trust investors (double the 1991 share) now put their money into index funds - trusts that track a stock market index. Roughly the same percentage of US mutual fund investors do the same, close to three times the proportion of five years ago. The absolute numbers are more impressive. The entire UK unit trust sector is worth about £70 billion, so the amount invested in index funds is a little over £1.5 billion. And that figure is dwarfed by US mutual funds, collectively worth over $3 trillion (or about £2 trillion), with index tracking funds accounting for just over $60 billion (or £40 billion) of that total.
Index funds are simplicity itself. They track well-known indices like the FTSE 100 or the S&P 500. The aim is the same whatever the index: the investment manager buys every stock in the index he wants to track or a representative basket of the shares. Then, if the index moves up 5%, so does your investment. This approach has a number of advantages. The investment manager has no need for a team of highly paid analysts to research share values.
That means charges on a tracker can be pared to the bone. The cheapest UK index tracking trust, for example, currently has no initial charge and an annual fee of just 0.5%. In the US funds are even cheaper - one fund is offering an annual charge of 0.2%.
Index trackers are also very easy to follow. When a newsreader announces that the stock market has risen by 1%, you know your fund has done the same. This is an obvious comfort for small investors nervous of more sophisticated investment products. The feeling of reassurance is more than psychological.
Index funds diversify risk, because if you buy every stock in the index you lessen the impact of a badly performing stock.
Of course, there are plenty of drawbacks. The downside of diversification is reduced returns. Index funds are safe rather than sexy - you'll never get an outstanding return on your investment. Indeed, any gains made are slightly below the performance of the index because charges, however small, eat into your investment.
In addition, most funds operate with a tracking error. For funds following the smaller, more conventional indices - the FTSE 100 or the S&P 500, say - that error should be small. Tracking larger indices - some funds follow the MSCI World Index, for example - is harder to get right. Finally, a tracker fund's investment policy contains no flexibility: the fund has to follow the index come what may. So when investment managers expect a downturn in the market, they can't move into more defensive assets like cash.
Equity investments are best seen as long-term bets. The markets are too volatile to go for short-term gambles with any certainty. And over five years, it is unusual for an equity-based index to lose value. Even if they do, there's no guarantee investment managers for an active fund are going to spot a market downturn. Their record for beating the indices over the long term is poor - the reason for considering index funds in the first place.