Low cost is all the rage – and rightly so given that inflation continues to rampage away at an annual rate of 10.5 per cent. Yes, it’s lower than it was (11.1 per cent last October), but it’s still corroding our household finances.
Value for money is also becoming increasingly important when it comes to how we invest our pensions and tax-friendly Individual Savings Accounts.
More than ever, investors are seeking out low-cost investment funds – usually run by robots – that track the performance of specific stock market indices such as the FTSE100, the S&P500 in the United States and globally, the FTSE All-World.
Alternative funds, run by managers who aim to outperform a specific index, are being shunned because they tend to have much higher annual charges that eat into investment returns. And, of course, aims are not always achieved, resulting in under rather than out-performance.
Finger on the pulse: More than ever, investors are seeking out low-cost investment funds – usually run by robots – that track the performance of specific stock market indices
According to the latest data from fund scrutineer Morningstar, fewer than a quarter of actively managed equity funds have outperformed their passive peers during the last decade. Over the year to the end of June 2022, the equivalent figure was slightly higher at 35 per cent.
By example, the popular £2.3billion HSBC FTSE All-World Index fund takes total annual charges of 0.13 per cent from the returns it generates from tracking the performance of global stock markets. Over the past five years, it has produced investor returns of 44.9 per cent.
In contrast, £2.8billion fund Baillie Gifford Global Alpha Growth strives to outperform – rather than replicate the returns from – global equity markets. Over the past five years, it has returned 40.1 per cent. Its performance numbers have been dragged down by annual charges totalling 0.59 per cent.
The impact of annual charges cannot be underestimated. Data provided by Vanguard, a manager of both low-cost trackers and actively run funds, shows that a £10,000 investment growing at five per cent a year would be worth £26,533 after 20 years without charges. An ongoing annual charge of 0.1 per cent would reduce this to £26,007 while a fee of 0.6 per cent would take it down to £23,524.
A report, to be published this week by Morningstar, will confirm a continued drift of investor money into low-cost funds. The data will show that over the past ten years, net flows into equity-based indextracking investment funds have exceeded those going into actively managed funds in nine of the ten calendar years.
Although indextrackers experienced more outflows last year than inflows, as investors took flight from falling stock markets – especially in the United States – they were a fraction of the money withdrawn from non-index funds. Morningstar says net flows out of index-tracking funds was £3.4billion, compared to £18.5billion for non-index funds.
Jonathan Miller, head of UK manager research at Morningstar, says investors are becoming increasingly ‘cost sensitive’. He says: ‘When stock markets are performing strongly, investors are content with the fact that their investments are growing in value, irrespective of cost. But when market conditions are more volatile, investment costs become a bigger issue.’
He adds: ‘In terms of investment simplicity, low-cost funds that seek to replicate the performance of well-established indices are the way forward.’ Despite this, 80 per cent of investors’ money sits in actively managed funds rather than index-trackers.
Alan Miller (no relation to Morningstar’s Jonathan) is a longstanding investment manager in the City, once running active funds for asset managers Jupiter and New Star.
But since setting up SCM Direct wealth management company in 2009, he has been a convert to low-cost investment funds such as index-trackers. He says: ‘Investment managers often say that the next 12 months will be good for stock pickers. But it’s nonsense. The long-term probability of success – beating the market – remains unchanged.
‘Think about it like tossing a coin. You may guess heads or tails correctly the first and second time, but the more tosses you have, the more your success rate will gravitate to 50 per cent.’
Alan Miller says that investment returns from both low-cost funds and actively managed funds must equal the market return over the long term.
But given investors receive their returns after fees, the average actively managed fund will always underperform the average low cost fund.
Miller says most managers investing in the UK stock market tend to under or out-perform because of asset allocation decisions rather than their ability (or non-ability) to pick winning stocks. Most tend to hunt for companies beyond the 100 largest listed on the UK market which means their performance numbers can look poor if the FTSE100 has a good year.
Last year, the FTSE100 rose by nearly one per cent while the FTSE250 – representing the next 250 largest companies by market capitalisation – fell by nearly 20 per cent. This was primarily a result of many FTSE250 companies having businesses exposed to a faltering UK economy.
In contrast, the FTSE100 boomed on the back of its proliferation of strong performing oil companies and mining giants.
Miller says: ‘This year, I wouldn’t be surprised if UK fund managers do well on the back of a stronger performance from the FTSE250. But, instead, I’d buy a FTSE250 index fund.’
Investment platform Hargreaves Lansdown says the best funds are HSBC FTSE250 Index and Legal & General UK Mid Cap Index. Respective annual charges total 0.12 per cent and 0.08 per cent.
One final point. Over the last seven calendar years, the average UK equity investment fund has underperformed the FTSE All-Share Index on four occasions.
By contrast, a hypothetical fund invested 50:50 in the FTSE100 and FTSE250 indices would have outperformed the average UK equity fund six times.
Hardly an overwhelming advert for active fund managers.
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