COMMENT
The Perfect Investment

By Cliff D'Arcy
August 5, 2005

When I discuss or write about investing, I refer only to investing in shares for the long term (for at least five years and, ideally, for ten or more).

I don't mean saving, which to me means putting money on deposit in a bank or building society. Hence, I get a little annoyed when some half-baked investment is referred to by its promoters as a 'savings plan'!

For me, investing means buying shares in good companies and holding onto them. As Peter Lynch, a top US fund manager, once remarked, "although it's easy to forget sometimes, a share is not a lottery ticket... it's part-ownership of a business". Thus, pick the right companies, and your investment should do well over time.

Indeed, the UK stock market has produced an average annual return of 11% since 1918, with dividends (the income paid by shares) reinvested. That easily outstrips the long-term returns from cash, bonds, and even today's favourite, property. However, note that gearing (borrowing money to invest) dramatically enhances the returns (and risks) of property investment.

Although I invest in individual shares myself, I know that many people lack the time, skill or experience to do their own research. Most of these folk end up putting money into collective investments, where a group of investors' money is pooled together by a fund manager, who buys and sells shares on their behalf. These are known as 'actively managed funds', because the manager and his/her team actively pursue their own investment strategy.

However, we Motley Fools are not huge fans of actively managed funds, because of what I call the "Ferrari factor". At least four out of five highly paid fund managers (over 80%) fail to deliver superior returns for their investors. In fact, thanks to their high upfront and annual charges (some funds even charge exit penalties), the vast majority of active fund managers fail to beat the market over a long period, say, twenty years!

As a result, the Fool believes that most investors would be much better off putting their money into cheap, simple index trackers, which passively track the stock market up and down with no human intervention. Thanks to their low charges, investors in trackers get more of their pot working right from the start, which gives them a clear short-term (and long-term!) advantage.

At the latest Fool Social, one new visitor was almost convinced by the Fool's argument for investing in trackers. This came after she discovered that her blue-chip fund management group had almost consistently failed to beat the market in recent years! However, I felt that she wasn't totally convinced, so here are some of questions and answers regarding trackers:

Q: Isn't it risky to put all of my eggs in one basket?

A: Not if the basket is big enough and sturdy enough! For example, investing in a FTSE 100 tracker gives you exposure to the UK's one hundred largest listed companies. These cover a wide range of industries and sectors, so they are widely diversified across the world economy. A FTSE All-Share tracker throws the net even wider: it encompasses around seven hundred listed firms!

A. Talking of the world economy, shouldn't I be investing outside of the UK, as well?

It's not a bad idea, but not essential, as many of the UK's biggest companies are truly global businesses. For example, BP, HSBC, Vodafone and GlaxoSmithKline make the bulk of their profits outside of the UK, as do many London-listed multinationals. Personally, I've only ever invested in UK-listed shares and UK tracker funds, but whatever floats your boat!

Q. Do tracker funds pay dividends?

Yes, of course they do! Amazingly, some IFAs (independent financial advisers) believe that they don't, and use this argument to slate them! For example, the dividend yield on the hugely popular Legal & General UK Index Trust (an All-Share tracker) is around 2.5%, which reflects the market yield of about 3.1%, less the fund's annual expenses of 0.54%.

Q. So, do you invest in trackers, then?

A. You bet I do! My contributions to the Fool's Stakeholder pension scheme are invested wholly in a cheap FTSE 100 tracker. Also, I buy iFTSE 100 shares, which you can learn about here. In addition, my wife's six-figure pension pot is invested in a FTSE tracker too, so we're putting our money where my mouth is!

Q. Can I shelter my tracker fund inside a tax-free ISA wrapper?

A. Yes, and I'd encourage you to do so! By investing in a shares mini-ISA (limit: £4,000 per tax year) or a shares maxi-ISA (limit: £7,000 per tax year), you can avoid paying tax on your dividends and capital gains (profits). Over the long term, a tax-free investment will significantly outperform a similar taxable investment, all other things being equal.

You can read more about investing in The Stock Market Needn't Be Scary! Good luck with your financial planning!

More: Invest in the UK's biggest index tracker with Fool Partner Legal & General.

Cliff owns shares in GlaxoSmithKline. Many thanks to Amy for inspiring this article!