When we decided, nearly 10 years ago to adopt index tracking funds into our client’s portfolios, the investment industry was quite different to today.
In 2007, investment processes were less precise, Margot Robbie had yet to explain what a sub prime mortgage was, and index tracking funds were only used by investors who “weren’t capable of picking a talented fund manager”.
The theory went that active fund managers could produce superior performance for investors by “stock picking” the best companies to invest in. Furthermore, they were able to “time the market” by investing more money into shares when they were expected to rise and vice versa.
By contrast, critics said that tracking funds were blunt instruments that blindly invested into both good and bad assets. The only benefit of using tracker funds was said to be that they attract lower management fees.
Ten years later, what lessons have we learned from our use of tracker funds?
Firstly, the cost differential is still a major factor to consider. A typical index tracking fund now has a published fee of around 0.15% per annum, with additional unpublished dealing costs contributing an extra 0.05% per annum. The average cost of an actively managed fund comes in somewhat higher, with published headline fees of around 0.75% per annum, and unpublished dealing costs adding a variable fee that could easily equate to an additional 1.4% per annum.
An investor who uses active funds in order to try and consistently outperform the underlying market (and therefore outperform index tracking funds) will face a difficult and therefore expensive task. That is not to say it is impossible, it is just that the millstone of higher fees makes it much more challenging for active funds to be able to offer value for money in the form of superior fund performance.
Apart from fund performance, one must also consider the degree of risk that is held within an investment portfolio. This is a particularly important consideration for trustees who are aiming to produce a prudent balance between investment risk and investment returns. Suppose the underlying funds are actively managed by a “star” fund manager who has set out his stall as a stock-picker. How can you be sure that the overall asset allocation remains appropriate to meet the trust’s objectives? What if the star manager decides he doesn’t like the look of the market and stockpiles cash? What happens if he thinks oil stocks will be the next big thing and he triples his exposure to this sector? All of a sudden your asset allocation has markedly changed and the portfolio’s risk characteristics are no longer appropriate to meet the trust’s objectives. You may have backed the right horse, but you’ve got the wrong jockey on board!
A more prudent way to manage a portfolio would be to use tracker funds where you know that your asset allocation will be as accurate as possible with no risk of drift caused by the proactive jockey. Whilst the major benefit of such a strategy is the perfect replication of the desired asset allocation, there is of course the welcome by product of low cost and therefore higher than market average returns.
This is borne out by the performance we have generated through our range of risk graded model portfolios. At each level of risk, we have been able to generate superior returns, with less volatility than the respective RTMA (Risk Targeted Multi Asset) sector average performance levels. The chart below shows that our Defensive and Balanced strategies (the blue dots) have each produced better performance, than the average multi asset funds (the red dots) for both low and medium and risk investors.
In our experience, investment solutions populated by active funds produce more variable fund performance than those using tracker funds. Just because funds can frequently trade to react to prevailing market conditions, it doesn’t mean that they should. It is not easy for an actively managed fund to consistently outperform the market as a whole, but the increased levels of fees will definitely create a significant drag to that fund’s performance.
It is important to always keep an eye on the big picture and remember that we are investors, not speculators. As unfashionable as it may sound, the most consistent method for delivering steady, risk-controlled returns is to choose a low cost, diverse long term strategy and then stick to it.
The Next Step
If you would like further information on the above post or to discuss your own specific circumstances please give the team a call on 01462 687337 or email firstname.lastname@example.org.
This blog first appeared as an article in Light Blue Law, The Cambridge and District Law Society Newsletter
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