Low cost is all the rage – and rightly so given that inflation continues to run wild at an annual rate of 10.5%. Yes, it is lower than it was (11.1% last October), but it is still eating away at our household finances.
Value for money is also becoming increasingly important when it comes to how we invest our tax-advantaged individual pensions and savings accounts.
More than ever, investors are looking for low-cost investment funds – usually managed by robots – that track the performance of specific stock indices such as the FTSE100, the S&P500 in the United States and, globally, the FTSE All-World.
Hedge funds, run by managers who aim to outperform a specific index, are shunned because they tend to have much higher annual charges that eat away at investment returns. And, of course, goals aren’t always met, resulting in underperformance rather than overperformance.
Taking the pulse: More than ever, investors are looking for low-cost investment funds – usually run by robots – that track the performance of specific stock indices
According to the latest data from fund scout Morningstar, less than a quarter of actively managed equity funds have outperformed their passive peers over the past decade. In the year to the end of June 2022, the equivalent figure was just over 35%.
For example, the popular £2.3bn HSBC FTSE All-World Index fund takes a total annual charge of 0.13% on the returns it generates by tracking the performance of global equity markets. Over the past five years, it has produced returns for investors of 44.9%.
By contrast, the £2.8 billion Baillie Gifford Global Alpha Growth fund strives to outperform – rather than replicate returns – global equity markets. Over the past five years, it has returned 40.1%. Its performance numbers were dragged down by annual charges totaling 0.59%.
The impact of annual charges cannot be underestimated. Data provided by Vanguard, a manager of low-cost trackers and actively managed funds, shows that a £10,000 investment growing at 5% per year would be worth £26,533 after 20 years with no fees. A continuing annual charge of 0.1% would reduce this amount to £26,007, while a 0.6% charge would bring it down to £23,524.
A report, to be released this week by Morningstar, will confirm a continued drift of investor money into low-cost funds. The data will show that over the past ten years, net flows to equity-based index investment funds have exceeded those to actively managed funds in nine out of ten calendar years.
Although index trackers saw more outflows than inflows last year, as investors fled falling stock markets – particularly in the US – they accounted for a fraction of the money taken out of non-index funds. . Morningstar says net outflows from index funds were £3.4bn, compared to £18.5bn for non-index funds.
Jonathan Miller, head of UK manager research at Morningstar, says investors are becoming increasingly “cost sensitive”. He says: “When stock markets perform strongly, investors are content with the fact that their investments increase in value, regardless of the cost. But when market conditions are more volatile, investment costs become a bigger issue.
He adds: “In terms of investment simplicity, low-cost funds that seek to replicate the performance of well-established indices are the way to go. Despite this, 80% of investors’ money is in actively managed funds rather than index trackers.
Alan Miller (no relation to Morningstar’s Jonathan) is a longtime investment manager in the City, who formerly ran active funds for asset managers Jupiter and New Star.
But since founding wealth management company SCM Direct in 2009, he’s converted to low-cost investment funds such as index trackers. He says: “Investment managers often say that the next 12 months will be good for stock pickers. But this is nonsense. The probability of long-term success – beating the market – remains unchanged.
“Think of it like tossing a coin. You can guess heads or tails correctly the first and second time around, but the more tosses you have, the more your success rate will hover around 50%.
Alan Miller asserts that investment returns from low-cost funds and actively managed funds should equal the long-term market return.
But since investors receive their returns after fees, the average actively managed fund will always underperform the average low-cost fund.
Miller says most managers who invest in the UK stock market tend to underperform or outperform due to asset allocation decisions rather than their ability (or lack thereof) to pick winning stocks. Most tend to look for companies beyond the 100 largest listed on the UK market, which means their performance numbers can look poor if the FTSE100 is having a good year.
Last year, the FTSE100 rose almost 1% while the FTSE250 – representing the 250 largest companies by market capitalization – fell almost 20%. This was mainly due to the fact that many FTSE250 companies had businesses exposed to a failing UK economy.
In contrast, the FTSE100 soared thanks to its proliferation of successful oil companies and mining giants.
Miller said: “This year I wouldn’t be surprised if UK fund managers were successful on the back of a stronger FTSE250 performance. But, instead, I would buy an FTSE250 index fund.
Investment platform Hargreaves Lansdown says the best funds are the HSBC FTSE250 Index and the Legal & General UK Mid Cap Index. The respective annual charges total 0.12% and 0.08%.
One last point. Over the past seven calendar years, the average UK equity investment fund has underperformed the FTSE All-Share Index four times.
In contrast, a hypothetical fund invested 50/50 in the FTSE100 and FTSE250 indices would have outperformed the average UK equity fund six times.
Hardly a damning advertisement for active fund managers.
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