Navigate the differences between index tracker ISAs (individual savings accounts) and managed funds and find out which investment method is best for your needs.
A tracker will never match its chosen index precisely. In fact it will almost certainly do slightly worse. This is due to two factors, tracking error and charges, which we look at in more detail in the following article about how to choose a tracker. But trackers do offer consistency. They will only lag the index by a small percentage, year in year out.
The same is not true of managed funds. 9 out of 10 managed funds don't manage to beat the index over the long-term. Yes, you did read that correctly -- 9 out of 10! Astonishing, isn't it. As trackers lag the index a little, the figures comparing their performance to managed funds aren't quite as impressive, but they are still significant. All the research that has been carried out has shown that the average tracker still beats 3 out of 4 managed funds over the long-term.
Therefore it makes a lot of sense going for a tracker. Other research has shown that it is impossible to reliably predict in advance which managed funds will do better than trackers over any given timeframe, for example by picking a fund that has done better in the past. So whilst you are never going to be top of the class with a tracker you are more or less assured of a very respectable position in relation to the rest of your classmates.
Why Trackers Beat Managed Funds
Why do managed funds do so poorly as a group? The first thing is to realise that, taken together, managed funds can't outperform the index. Why? Taken as a group, they are the market (and therefore the index). You can't outperform yourself. It's the bit like the fact that most drivers think they are better than average. It's just not possible.
Trackers do better than most managed funds primarily because their charges tend to be a lot lower. They don't employ expensive fund managers that make numerous buy and sell decisions that in the end merely cancel each other out. Trackers typically have no initial charge and an annual management charge of 1% or less. Managed funds on the other hand have initial charges of up to 5% and annual charges of around 1.5%. On top of that they also tend to buy and sell more shares each year, so they incur more in the way of dealing charges too. Now these amounts may not sound like a lot but over 5 years or more, these charges start to add up and it means that managed funds lag trackers by a considerable amount.
Say you put £1,000 into a managed fund and £1,000 into a tracker, and before charges they both grow at 11% a year -- not a bad performance at all! However, the combination of initial charges and annual charges takes the managed fund's return down to 8.5% a year, while the index tracker charges no initial fee and 1% a year, taking its return down to 10% a year.
After 10 years your managed fund would be worth £2,261 but your tracker would be worth £2,594. Over 20 years the managed fund would grow to £5,112 and the tracker would return £6,728. So your extra 1.5% a year return means that your final sum after 20 years would be 24% higher. That's why we have a saying at the Motley Fool - small differences in annual returns matter, a lot!
Index tracking funds are a relatively new phenomenon in the UK. Before the 1990s there were few of them around. But the surge in the stock market in the last 20 years has helped alert people to their attractions. The returns for the next twenty years are unlikely to be as spectacular, as inflation is low for starters. But all the historical evidence points to the fact that over periods of 5 years or more shares tend to do a lot better than cash in the vast majority of cases (over 80% of the time in fact). The longer the time period you look at, the better the relative performance of shares against cash becomes. So despite the recent decline in the stock market, investing still makes sense -- provided you are in the game for the long term. You can't guarantee success, but the odds are heavily stacked in your favour.
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