The Motley Fool

Why Index Trackers Make Sense

Having decided that we want an investment fund, how do we choose one from the thousands that are available? Don’t worry, it’s a lot more simple that it might first appear.

The two basic types of funds

Funds can be split into two basic types. There are ‘active’ or ‘managed’ funds where the fund manager picks and chooses the shares on your behalf, getting paid handsomely for the privilege we might add.

Then there are ‘passive’ funds that merely buy the whole market or a certain section of it. These are known as index trackers because they attempt to track an index. An index measures the overall performance of a group of companies, such as the FTSE 100 (the 100 largest shares on the London Stock Exchange).

The ‘active’ vs ‘passive’ debate

Active sounds much more fun doesn’t it? We all want to beat the market. By definition, before we take charges into account, half of our investment will do better than the overall market and the other half won’t. When you take off charges and transaction cost, you can see that it’s inevitable that most funds will underperform the market. We put that in bold, because we think it’s rather important.

What this means is that, most people are better choosing a fund with low charges. And passive funds have the lowest charges. They are run by computers and computers tend to be a lot cheaper to run than fund managers. They don’t eat, drink, drive fast cars, have to pay a mortgage or send their kids to posh schools.

In fact, studies have shown that over the long term (by which we mean 5 years+) index trackers tend to beat about three quarters to four fifths of managed funds.

Of course, there will always be some funds that do better than index trackers. The only trouble is identifying them in advance. Some people claim they can, although it’s a lot more difficult than you might think. For one thing, oodles of research has shown that the past performance of a fund is no guide to its future performance.

For your first investment though, you want to keep things both simple and cheap — and we thinks that means some sort of index tracker. So, begone managed funds!

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