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Low costs are all the rage – and rightly so given that inflation continues to rise at 10.5 percent annually. Yes, it’s lower than it was (11.1 percent last October), but it’s still hurting our families’ finances.
Value for money is also becoming increasingly important when it comes to investing our pensions and tax-friendly Private Savings Accounts.
More than ever, investors are looking for low-cost mutual funds – usually run by robots – that track the performance of specific stock market indices, such as the FTSE100, the S&P500 in the United States and the FTSE All-World globally.
Alternative funds, managed by managers who aim to outperform a specific index, are shunned as they tend to have much higher annual fees at the expense of investment returns. And of course goals are not always achieved, resulting in under-performance instead of over-performance.
Finger on the pulse: More than ever, investors are looking for low-cost mutual funds – usually run by robots – that track the performance of specific stock market indices
According to the latest data from fund controller Morningstar, less than a quarter of actively managed equity funds have outperformed their passive counterparts over the past decade. For the full year to the end of June 2022, the equivalent figure was slightly higher at 35 percent.
For example, the popular £2.3 billion HSBC FTSE All-World Index fund derives a total annual cost of 0.13 per cent from the returns it generates by tracking the performance of global stock markets. Over the past five years, it has delivered an investor return of 44.9 percent.
By contrast, the £2.8bn Baillie Gifford Global Alpha Growth fund aims to outperform returns from global equity markets. Over the past five years, the return has been 40.1 percent. Performance figures have been dragged down by annual costs totaling 0.59 percent.
The impact of annual charges cannot be underestimated. Data from Vanguard, a manager of both low-cost trackers and actively managed funds, shows that a £10,000 investment growing at five per cent a year would be worth £26,533 after 20 years with no fees. An ongoing annual fee of 0.1 per cent would reduce this to £26,007, while a 0.6 per cent fee would reduce it to £23,524.
A report released this week by Morningstar confirms a continued shift from investor money to cheap funds. The data will show that over the past decade, net inflows into equity-based index-tracking mutual funds have exceeded inflows into actively managed funds in nine calendar years out of 10.
While index trackers experienced more outflows than inflows last year, as investors fled from falling stock markets – especially in the United States – they represented a fraction of the money withdrawn from non-index funds. Morningstar says net flow from index funds was £3.4bn, compared to £18.5bn for non-index funds.
Jonathan Miller, Head of UK Manager Research at Morningstar, says investors are becoming “cost conscious”. He says, “When equity markets perform strongly, investors are happy to see their investments grow in value, regardless of cost. But when market conditions are more volatile, investment costs become a bigger problem.”
He adds: “In terms of investing simplicity, cheap funds that try to replicate the performance of established indices are the way to go.” Despite this, 80 percent 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, once managing active funds for asset managers Jupiter and New Star.
But since he founded the asset management company SCM Direct in 2009, he has moved to low-cost mutual funds such as index trackers. He says, “Investment managers often say the next 12 months will be good for stock pickers. But it’s nonsense. The probability of long-term success – beating the market – remains unchanged.
Think of it like flipping a coin. You can guess heads or tails correctly the first and second time, but the more rolls you have, the more your success rate will increase to 50 percent.’
Alan Miller says that the investment return of both low-cost funds and actively managed funds should match the market return over the long term.
But since investors receive their returns after fees, the average actively managed fund will always underperform the average budget fund.
Miller says most managers who invest in the UK stock market tend to underperform or outperform because of asset allocation decisions than because of their ability (or inability) to pick winning stocks. Most tend to hunt companies outside the 100 largest listed in the UK market, meaning their performance numbers could look bad if the FTSE100 has a good year.
Last year, the FTSE100 rose nearly one percent, while the FTSE250 — which represents the next 250 largest companies by market capitalization — fell nearly 20 percent. This was mainly due to the fact that many FTSE250 companies had businesses exposed to a faltering UK economy.
In contrast, the FTSE100 soared thanks to the proliferation of outperforming oil companies and mining giants.
Miller says: “I wouldn’t be surprised this year if UK fund managers do well thanks to a stronger performance from the FTSE250. But instead I would buy a FTSE250 index fund.”
Investment platform Hargreaves Lansdown says the best funds are HSBC FTSE250 Index and Legal & General UK Mid Cap Index. The respective annual costs total 0.12 percent and 0.08 percent.
One last point. Over the past seven calendar years, the average UK equity mutual 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 by six times.
Not an overwhelming advertisement for active fund managers.
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