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Weekend reading: Look for low expense ratios not star power when investing in funds

What caught my eye this week.

Every few days a comment is left by a new visitor to this website – or I’ll get an email via the contact form [1] – telling us we’re mistaken to champion passive funds as the best choice for most investors.

The reason given is invariably the past performance of manager X or of fund Y. (We’re also invariably informed the commentator has been investing in it for Z years and has done very well, thank you very much.)

Depending on how eloquent the comment is, I may publish it . Sometimes I’ll reply to it, and explain the shortcomings. Often I delete the glib ones.

Now before someone screams “censorship!” imagine how you’d feel replying to the same erroneous line of reasoning for ten years, from people who don’t know half as much as they think they do but are twice as confident about it as you are – and also remember that publishing their comment unchallenged could mean another reader sees it and embarks on a money-wasting strategy, despite the best intentions of your own website.

See? Delete!

It’s just not worth looking for winners

The evidence shows most active funds underperform [2]. Anecdotal asides that this or that fund has done better from a fly-by-night commentator simply highlight the exceptions.

Of course, some active funds do outperform. Some will be lucky, but as an active stock picker myself [3], I happen to believe that genuine investing skill exists, too. It’s just that very few funds demonstrate it – making it very unlikely you’ll be invested in one that beats the market, let alone the half a dozen you’ll need for a well-diversified portfolio – and that active funds cost more – meaning that searching for the needles in the haystack will reduce your returns [4].

Low returns in turn mean you’ll have less money to spend when you retire. Which means you’ll be able to buy fewer things you need, or that your money will run out sooner. The decision to try to beat the market against all odds has big consequences.

Unless you’re an investing nut, why bother? Go passive.

Stars in their eyes

The allure of buying better funds persists though, and it’s not hard to see why.

Mostly in life we hire experts and pay more for the better ones. Investing is weird in that doing the complete opposite is a better decision. But people understandably struggle with the concept. It feels wrong [5]. They look for other approaches, but they’d do better to spend more time getting their head around the merits of cheap index funds.

This week for example the Wall Street Journal made a big splash in the financial gossip-o-sphere pointing to the allegedly poor predictive value of Morningstar’s five-star rating system.

Unfortunately the article [6] is behind a paywall, but the introduction sums up the accusation:

Investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer – it doesn’t.

For its part Morningstar disagrees with the Wall Street Journal‘s claim. The company wrote a detailed rebuttal, concluding that:

The Journal’s story notwithstanding, the star rating has been a useful starting point for research that tilts the odds of success in investors’ favor.

The forward-looking Analyst Rating, while newer, has also exhibited predictive power.

Used together, or separately, we think these ratings can improve outcomes and help investors achieve their goals, which is entirely in keeping with our mission as a firm.

I don’t know whether Morningstar’s rating system on average directs investors to the better-performing funds of the future. (Anyone can point to the winners with hindsight.) We’ve noted before that rating systems and best buy lists are pretty useless [7] for passive investors anyway. And while I am an active investor, I buy companies, not open-ended active funds, for myriad reasons.

However I’m inclined to agree with Barry Ritholz who writes over at Bloomberg that [8]:

It should come as no surprise that misunderstanding what fund ratings mean is a very typical error made by, well, just about everyone.

It isn’t a forecast of future returns, nor could it be. If it could successfully do that, Morningstar would have long ago set up a hedge fund to profit from its newly discovered abilities to identify winning investments.

As Ritholz also points out, Morningstar itself has regularly pointed to [9] low expense ratios as “the strongest predictor of performance.”

And in case you haven’t been paying attention, it is passive funds that have the lowest expense ratios. So this finding is code for ‘passive funds beat active funds.’ Again.

You’ll find a list of the cheapest passive funds [10] for UK investors on this very website.

From Monevator

Patient investing requires a little faith – Monevator [11]

Monevator readers discuss fee changes at Interactive Investor / TD Direct – Monevator [12]

From the archive-ator: 10 reasons why houses are a better investment than shares – Monevator [13]

News

Note: Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber.1 [14]

Average credit card rates now 50% higher than before the financial crisis – Telegraph [15]

Workplace pension charges to go online in transparency push [Search result]FT [16]

The top 10 UK tax complexities [Search result]FT [17]

Britain is ready for an interest rate rise, says Lloyds boss – Guardian [18]

Jack Bogle: Vanguard might be about as big and as cheap as it can get – Morningstar [19]

Fees on the world’s cheapest ETF portfolio are down to 0.05% – Abnormal Returns [20]

Products and services

What you need to think about when writing a will – ThisIsMoney [21]

3-year Poppy Bond ISA pays 2% – and 0.15% to Royal British Legion – ThisIsMoney [22]

New Amazon service will enable couriers to open customers’ front doors – BBC [23]

Interactive Investor and TD Direct fee changes: how much will you pay? – Telegraph [24]

Help to buy has mostly helped housebuilders – Guardian [25] [As – ahem – I predicted [26]!]

I lost £109k in Santander smishing scam – and the bank did refund‘: Three key steps to stop you falling victim to fraud at the bank – ThisIsMoney [27]

Comment and opinion

What the charts don’t tell you about stock market crashes – A Wealth of Common Sense [28]

Investing in unicorns – Fire V London [29]

Unilever has ‘expensive defensive’ written all over it – UK Value Investor [30]

Value investors: There’s always something you don’t love [Podcast]Meb Faber [31]

It takes no talent to keep predicting a stock market crash – The Reformed Broker [32]

Passive investors should never laugh at active – The Macro Tourist [33]

Have active managers given active management a bad name? – Morningstar [34]

Get rich with conspicuous consumption – Mr Money Mustache [35]

The fund for emergencies and piss-poor financial planning – 3652 Days [36]

The three great misconceptions about retirement saving – Can I Retire Yet? [37]

Cryptocurrency and blockchain

Bitcoin, blockchain, and cryptocurrency [Excellent introductory podcast]Motley Fool [38]

Bitcoin’s bewildering race to $100 billion – Bloomberg [39]

The Bitcoin boom: Asset, currency, commodity or collectible? – Musings on Markets [40]

The flood of cryptocurrency ICOs is an echo of the dotcom boom – The Value Perspective [41]

Off our beat

Nerds and nurses are taking over the US economy – The Atlantic [42]

How I spent three years becoming a minimalist and why you should too – Medium [43]

Does getting super-rich mean getting a taste bypass? – Simple Living in Somerset [44]

And finally…

“Go ahead, take a look at reality. You’re floating in empty space in a universe that goes on forever. If you have to be here, at least be happy and enjoy the experience. You’re going to die anyway. Things are going to happen anyway. Why shouldn’t you be happy? You gain nothing by being bothered by life’s events. It doesn’t change the world; you just suffer. There’s always going to be something that can bother you, if you let it.”
– Michael A. Singer, The Untethered Soul [45]

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  1. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. [ [48]]