Index Trackers Vs Managed Funds

Whether index trackers are better than managed funds is the cause of a fair amount of controversy in the world of investment. The evidence is fairly clearcut however, and it shows index trackers beat the vast majority of managed funds over the long term.

For instance, a study by research firm WM Company found that 82% of managed funds failed to beat the market over the course of twenty years. While you may think that sounds bad, this figure only includes funds that managed to survive for the whole twenty years. Many poorly performing funds are shut down or get merged into other funds. This means that the chances of picking a fund now that will do worse than the market over the next twenty years is likely to be a lot higher than 82%, and is probably well in excess of 90%. Some people believe however that it's possible to consistently pick one of the few funds that will beat the index, although this too is hotly debated and not backed up by research.

Why do managed funds disappoint?

So why do managed funds perform so badly as a group?

Taken together, managed funds essentially are the market. This means that collectively they hold their investments in pretty much the same proportion as an index tracker does. Before taking costs into account therefore, you'd expect a managed fund and an index tracker to produce the same sort of return.

When you take costs into account however, they are two key differences between index trackers and managed funds:

Charges

Firstly, charges for managed funds tend to be a lot higher than index trackers. A typical managed fund charges around 1.5% a year, whereas the average index tracker charges around 0.8% and some charge as little as 0.3%. These differences may sound small but they compound each year and give index trackers a huge advantage over the long term. (Note that because index trackers charge a small amount each year, you would normally expect their performance to trail the index by a similar amount each year.)

Turnover

The second difference is that managed funds trade more frequently. The typical UK fund turns over around 50% of its holdings each year. The dealing costs and stamp duty associated with this activity give managed funds an additional handicap to overcome when pitched against index trackers, which tend to have annual portfolio turnover of less than 20%.

Interestingly, one of the criticisms levelled at index trackers is that they are forced to buy shares at inflated amounts when changes are made to an index. This is true to some extent but as we can see despite these forced changes index trackers still buy and sell shares far less frequently than most managed funds. Tracker-bashers also point out that a tracker investment is concentrated in a handful of companies and a few sectors (currently banks and oil dominate here in the UK). This again is true but it has also been a characteristic of the UK market in most previous decades, with no apparent ill effects.

Given their poorer performance, managed funds have more questions to answer it would seem, especially 'closet trackers'. These are funds whose holdings differ little from an index tracker's, but which still charge the high fees associated with managed funds.

The difference in returns

So, if an index tracker were to perform, say, 1.5% better each year than a managed fund, what difference could this make to you? Let's say you put £1,000 into a tracker and £1,000 into a managed fund. The former grows at 10% a year, the latter at 8.5% a year.

After ten years your managed fund would be worth £2,261 but your tracker would be worth £2,594. Over twenty years the managed fund would grow to £5,112 and the tracker would be worth £6,728. So your extra 1.5% a year return results in 24% more cash for you at the end of twenty years.

As well as a higher expected return, index trackers have one final major advantage over managed funds. And that is there are much simpler to operate. Essentially, you can just pick your tracker and leave it to do its job for twenty years and even longer. If you favour the managed fund route, not only do you have a bewildering number to choose from in the first place (several thousand in fact), you also have to continually monitor the fund's performance and even pick another fund should its returns fail to inspire or its manager depart for elsewhere (a fairly common occurrence).

All things considered, here at the Fool believe that an index tracker is the most suitable investment vehicle for the vast majority of people.