I always thought I wouldn’t, but I’m afraid I’ve become one of those tedious parents who lecture their children on the folly of paying for designer clothes. There are times I seem to be making progress. My son even agreed recently to wear a jacket his mum bought from the supermarket as long as she took the label out. Regrettably, though, I’m pretty much resigned to paying to deck them out in the latest haute couture for the rest of their teenage years.
But they’ll jolly well have to listen to me when they start investing for their future. Investing’s equivalent of designer clothes are actively managed mutual funds. Newspapers love to write about them (and love even more the advertising revenue they generate). Advisers love to talk about them. We love to buy them. And boy, are they expensive.
Yet, take a closer look, and the majority of actively managed funds turn out to be very similar, and in some cases more or less identical, to products you can buy off the shelf far, far more cheaply.
Take, for example, the latest research by SCM Direct. The study shows that any outperformance by UK actively managed equity funds over the last five years can largely be explained by their exposure to small- and mid-cap stocks. It’s generally accepted, that, over the long term, shares in smaller firms will tend to deliver higher returns — albeit with a greater degree of risk — than shares in larger firms. This is sometimes called the size premium. But there are far cheaper and more efficient ways of capturing the size premium than through actively managed funds. You can, for example, track the FTSE 250 for as little as 0.07% a year.
This new study comes hot on the heels of a previous SCM report on the growing number of so-called closet index trackers, in other words, funds that purport to be active — and command the high fees associated with active funds — but which in fact more or less track an index. Of course, by far the most efficient way to track an index and capture market returns cost-effectively is via a genuine index fund.
Over time, the money you save by using proper passive funds is huge. For someone earning around £50,000 a year, it comes to about £300,000 over the 40-plus years or so that people typically invest for their retirement over. That’s a huge amount of alpha that your chosen active manager needs to find, just to offset the additional cost of using them.
Furthermore, the price difference between index funds and that ultimate status symbol of the investing world, the hedge fund, is on a completely different scale. Yet recent research from Australia suggests that increasingly even hedge funds are giving up on the search for alpha and resorting to hugging benchmarks instead.
There are two challenges here for journalists, like me, who want to help investors to cut through all the industry spin and see what’s best for them. The first is to disabuse consumers of the notion that the more you pay for a fund, the higher the return you can expect that fund to generate. Usually, after costs, the very opposite is true.
The second challenge is to explain that, just because they’re cheap, that doesn’t mean passive funds are in any way inferior. Again, the opposite is true. They enable ordinary investors, for just a few basis points, to own a stake in hundreds of the top publicly-listed securities in practically any market. Nor, despite the impression that active management enthusiasts like to give, are passive funds in any sense unsophisticated; it takes considerable skill and effort to track an index accurately.
In short, if you pay for an actively managed fund you really are paying for the label — the brand, the PR the advertising — as well as the salaries of the managers and the considerable costs involved in buying and selling stocks. Even if you like a particular manager’s chosen strategy, you and your adviser can almost certainly replicate it for a tiny fraction of the cost.
By the way, I must confess that part of me sympathises with my children’s predilection for designer brands. They’re not teenagers for long, and if they want to blow their pocket money on some extortionately priced garment that’ll be out of fashion before the end of term, that’s down to them. But investment funds aren’t fashion accessories. And, when the time comes, I’ll take great delight in recommending the cheapest and, yes, most bland and boring I can find.