We look at four common reasons put forward as to why you shouldn’t invest in index trackers. None of them stand up to scrutiny.
Investment professionals can’t stand index trackers. They charge a lot less than ordinary funds and typically don’t earn advisers any commission. They also hate the fact that all their efforts can be outsmarted by what is essentially a straightforward and purely mechanical approach to investing.
Whilst index trackers aren’t perfect, they are certainly the simplest way to invest in the stock market and over very long investment horizons (which most people have) they’ll be beaten by just a small proportion of managed funds. Nevertheless investment professionals will usually trot several arguments as to why we shouldn’t buy index trackers and pay them lots of money instead. Let’s look at four of the most frequently mentioned.
They always underperform the market
There’s no escaping this one. Index trackers will underperform the market due to the cost of running the fund. But this is what they are designed to do and at least they won’t underperform the market as much as the average managed fund!
Trustnet lists around 650 UK funds with a five-year track record and both F&C’s FTSE All-Share tracker and Fidelity Moneybuilder, two of the lowest cost funds, have beaten over 70% of them. When you add in funds that have closed or merged over the last five years, or look at longer periods, the index trackers will have done even better.
They’re forced to buy and sell shares
Every quarter the FTSE 100 index of shares is revamped and typically three or four companies will be replaced. Index trackers have to sell these shares and buy the new entrants, regardless of the share prices prevailing at the time.
Again this is strictly true. However, the sums involved as a proportion of the total market value of the FTSE 100 are tiny. We’re usually talking less than 1% here. Even given these ‘forced’ transactions, the average index tracker turns over its investment portfolio far less than the average managed fund. An index tracker buys and sells around 10% to 20% of its portfolio a year whereas the figure for the average managed fund is nearer 60%.
The higher transaction charges borne by managed funds translate to around 1% a year in reduced performance. As a managed fund typically also charges 1% more than the cheapest index trackers, this means its underlying investments have to perform 2% better a year just to keep pace. That’s a handicap few funds can overcome in the long haul.
They’re no good in a bear market
Again this is true, but then this applies to most funds and not just index trackers. There seems to be a perception that fund managers can move out of shares and into cash en masse and cleverly sidestep any fall in the stock market. This is nonsense of course. Nearly all funds remain fully invested and over the course of the last year index trackers and UK funds have produced a similar 20% loss.
Predicting a fall in share prices is never as easy as it sounds. It’s easy with hindsight of course, but given that shares tend to spend more time going up than down (hard to believe at the moment I know) people who predict downturns tend to be wrong a lot more often than they are right and their performance suffers accordingly.
You’re concentrated in a few sectors
Again this is factually correct. But this is the way stock markets tend to work. Sectors fall in and out of favour all the time. So while the FTSE has suffered recently due to decline in banks and housebuilders, its holdings in mining and oil shares have mitigated this effect and certainly boosted performance over the last few years.
Fund managers would argue that they can select sectors which will outperform and ditch those headed for a downturn. A few may be able to do this but the evidence from long-performance figures is that the vast majority can’t.
Index trackers won’t make you rich overnight but they are far away the most cost and time effective method of benefiting from the long-term returns that the stock market offers. There is nothing wrong with trying to beat the market of course – it’s better than keeping cash in the bank – just as long as you’re aware that the odds aren’t stacked in your favour.
More: Ten Top Trackers | The Cheap And Cheerful Way To Invest In Shares
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