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Cut out the expensive middlemen with cheap index funds

Whether you’re swayed by the academic theories against active investing – or just the abundant proof showing most fund managers demonstrably fail to beat the market – the case for index investing is overwhelming.

No wonder the lucrative active fund industry has been battling indexing since the latter was introduced in the 1970s.

Jack Bogle, who as the founder of Vanguard group did so much to popularise index funds, even saw his competition decry passive investing as un-American!

It didn’t work.

Today Vanguard is one of the largest managers in the world by assets under management (although crucially, with its low-cost index funds it makes much lower margins on those assets than its more active rivals).

Fidelity, another big player in index funds, is also high up the rankings.

Index funds still on the rise

Yet despite the success of Vanguard, Fidelity, and iShares here in the UK (which is now owned by the giant Blackrock), overall active investing still has a bigger market share than passive investing.

That seems incredible, if you just consider the evidence we’ve seen in this video series from Sensible Investing.

Clearly still more people need to be hear the somewhat counterintuitive case for index funds, as outlined in the next video.

It features loads of different voices, ranging from John Redwood MP to Merryn Somerset-Webb to Monevator favourite Larry Swedroe:

As the video points out, none other than market-beater extraordinaire Warren Buffett has repeatedly made the case for index funds.

Buffett famously said:

“When the dumb investor realises how dumb he is and buys an index fund, he becomes smarter than the smartest investors.”

Most recently, Buffett revealed his wife’s estate would be put into an index fund after he’s passed on.

Just think about it.

One of the world’s greatest active investors – one of the few with any kind of long-term record of success, let alone Buffett’s 60-year streak – is effectively telling you not to bother even trying when it comes to active investing.

It’s a bit like Jamie Oliver telling you to keep out of the kitchen, for your own sake.

Do as he says or do as he does?

I believe that for all his folksy sayings about being greedy when others are fearful and so on, Warren Buffett – an investing genius – knows just how hard it is for most people to beat the market.

Tens of thousands of the world’s smartest and best-paid people still try every day. Most fail after costs.

Will you really do better than them?

If you want to invest actively for some other reason (I pick stocks myself) then fair enough.

But don’t do it because you think you’re the next Warren Buffett, or because you think it’ll be easy to beat all the other wannabe Buffetts out there.

The chances are you won’t even beat Buffett’s best bet – a cheap index fund.

Check out the rest of the videos in this series so far.

{ 22 comments… add one }
  • 1 Tufty October 2, 2014, 7:56 pm

    I really want to get into passive investing, but I just dont see how it can do better than active investment funds. If you look at most of the fund performance tables that Hargeaves show, they fluctuate yearly around double digits. Whereas passive trackers (eg ftse trackers) probably only dilly dally a percent or two. So how can passive trackers beat active funds? Even if you take managers fees off, most active funds still beat passive funds. I just look at all the charts on Hargreaves website and their Investment Times, and the yearly performance stats are much better than passive funds! Id be happy to be proved wrong, as passive investing in a Vanguard fund (for example) would be a lot easier for me!

  • 2 pkora94 October 2, 2014, 9:45 pm

    I read an article in the investors chronicle where a large percentage of uk active funds do beat the ftse all share and there are quite a few small cap active funds that do well but only a few global, japanese, europe ex uk and emerging markets that outperform their benchmark. Passive is much easier if you do not want the hassle of monitoring underperformance as long as you find the right tracker as there are some expensive trackers as well which do not follow the benchmark accurately either.

  • 3 sadteacher October 3, 2014, 12:36 am

    @tufty I don’t think it’s true to suggest that passive funds all muck around with small gains. Have a look at the annual return on this:
    http://www.hl.co.uk/funds/fund-discounts,-prices–and–factsheets/search-results/v/vanguard-ftse-uk-equity-index-accumulation

    If you’re asking how it is possible that passive funds beat the best active funds, the answer is… they don’t. So if you think you can reliably pick the best performing active fund year-in, year-out, then you should go all-in, and if you’re right, you’ll be laughing. If.

    Most people will not want to take that kind of risk, so they will diversify across a range of funds. What do you have when you own a basket of well-diversified active funds? Basically, you own the market… minus 1% fees. If you own tracker funds, you also own the market… but minus 0.08% fees.

    Once you realise that all the funds and shares in existence together constitute the market, then it’s clear that on average and over time, passive is cheaper than active.

  • 4 Tufty October 3, 2014, 9:19 am

    @sadteacher: Thanks for the reply. My current situation is that I have money to invest each month, but I am VERY lazy! 🙂 I dont want to keep reading the Investment Times; looking at share prices and worrying when a fund goes down. I am also not greedy – as long as Im doing better than inflation and Im not being taxed (I hold everything within my NISA) then thats good enough for me.

    But I cant help looking at the performance charts in the Investment Times – and they are all much better than passive trackers. I spent last night watching all the “How to win the losers game” episodes, and I know that Im getting stiffed by wealthy fund managers, but then I look at the performance charts and its clear that the funds that HL touts do outperform the market, even though I keep hearing that only “1% of fund managers beat the markets”.

    I keep going back and forth on the subject (I have been for a few years now!). But I always come back to the performance tables and think “surely these figures speak for themselves!”.

    The Vanguard fund youve linked to looks interesting. I guess I need a bit of handholding. I was going to follow one of Monevator’s ‘Lazy Portfolios’.

  • 5 The Investor October 3, 2014, 9:56 am

    @Tufty — I can’t reply in detail, it’s a huge subject — that’s why we’ve created this blog. 🙂

    If you’re watching all the videos and reading the links (e.g. The study done cited under the ‘proof’ link in the copy above) and you’re still not convinced then maybe active is for you.

    Keep in mind that there will be funds that beat the market *every single year*. It’s guaranteed. If it wasn’t for fees maybe 50% would beat the market (though more likely fewer, as success tends to skew). It’s a zero sum game, so in any one year say 50% might win at the expense of 50% that lose, to oversimplify (and crucially to ignore costs).

    What matters is what happens over the long-term. The research shows a lack of persistence (i.e. past winners rarely keep winning) and says it’s hard to predict who will winning next (which works against a swapping strategy). I actually think Hargreaves Lansdown tries pretty hard to pick winners, but I’m not aware that Noble prize winners have had to return their prizes to Bristol by way of defeat. 🙂

    Remember too there are a huge number of funds out there — way more funds than main market UK shares, ironically enough! So there’s a huge pool to find a few winners from in any year.

    It’s not in the spirit of passive investing to discuss the short term, so I’ll just briefly mention that this has been a good few years for active fund managers to try to beat the UK market. The FTSE 100 is dominated by 10 megacaps. Five make up (from memory) something like 40% of the index. So not holding those megacaps has been one easy way to deliver alpha. That might change at any time, if the megacaps perform.

    But as I say, do what feels right to you. Active investing can work for people, if you pick good broad funds without very high fees (i.e. Avoid high annual charges and performance fees) and don’t chase performance (i.e. Find and stick with managers you like, rather than chasing hot sectors/funds). It’s in some ways cheaper these days than it was (no up-front fees) though other fees have been buried in the cost structure that can makes it more expensive.

    If you select good broad active funds and regularly invest over 30 years you’ll probably do well. The evidence suggests you’d do markedly better with passive funds due to costs, but it’s not a case of top-drawer active funds crashing and burning — active investor behaviour (chasing hot funds, perhaps via those lists of recent good performers!) plays a big role in why active investing strategies fail, too, as well as costs.

    If you hold a few active funds (too many and you create a closet tracker) there’s a small chance you’ll beat the market. There’s no chance with passive investing. So if that small chance is important to you, then active is the only choice (though you could split your risks by going 50/50 say). I pick stocks so I’m not going to judge you. 😉

    I’d question if it is important to you given what you’ve written here, but it’s entirely your decision. We’re just strangers on the Internet. 🙂

  • 6 magneto October 3, 2014, 10:12 am

    Find that active funds do well until I buy them! Then they underperform!

    Re the mention of Warren Buffet, see he now admits buying 4% stake in Tesco was a bad mistake. Wonder how he will proceed from here? Sell and realise a loss, double up, or just hang on?

  • 7 Passive Investor October 3, 2014, 10:24 am

    @Tufty

    I was in the same state of mind as you when I started investing 25 years ago. I felt it was obvious that anyone would want to invest with the best performing funds who “obviously” would have the most skilled managers who “obviously” would perform better going forward etc. It was only after 5 or 6 years, when all the funds I picked did worse or no better than average after I bought them, that I began to think about it and luckily for me discovered passive investing young enough to save myself a lot of money. (I didn’t realise it then but I was experiencing mean reversion of active-manager performance.)

    Sadly in the mid 90s in the UK information was hard to come by and the only index fund in the UK was Virgin which charged 1%. Happily the situation is much better now and there are great sites like Monevator and dirt-cheap index funds from Vanguard, iShares, Legal and General, HSBC and others.

    I really advise you to read the Monevator site and possibly also buy a good index investing book but here are a few quick comments.

    If you are tempted to pick stocks, ask yourself why you should be a better stock picker than the tens of thousands of professionals with degrees in finance who work at analysing the companies you might choose hour after hour.

    If you are tempted to pick funds, ask yourself how you (or Hargreaves Lansdown or anyone else) can tell IN ADVANCE who is going to be the next Neil Woodford, Anthony Bolton. (As an aside Anthony Bolton’s experience in China is surely tellingly relevant to those who argue that even the apparently most skillful investors are really just lucky).

    To invest wisely the only rules you really need are

    (1) invest when you can and always for the long-term (ie buy and hold)
    (2) pick a bond : equities ratio that suits your risk profile – you need to be able to stay invested and be calm when you lose 30% of your equity investment in a bad year
    (3) invest in the lowest cost index funds across a range of markets

    Everything else is detail.

    Good luck

  • 8 Passive Investor October 3, 2014, 10:31 am

    @ magneto – see my comments above but your observation isn’t coincidence, it is regression to the mean (aka mean reversion). Imagine 10,00o people tossing a coin ten times and then choosing the 10 who got 10 heads. Now ask these ten “skilled” coin tossers to toss 10 times again. No surprise that none of them get much more than 5 or 6 heads this time around. So it is with fund managers…. (with the possible exception of a tiny number who it is only possible to identify with hind-sight)

  • 9 Tufty October 3, 2014, 11:04 am

    Thanks guys, some useful/detailed replies there. Im still confused as to what to do, although I certainly think Ill start putting some money away in a tracker within my SIPP.

    I should point out that Ive been following monevator for a few years now, and because of it I have invested a bit in the Vanguard 80% tracker. But I still hold onto active funds that I initially invested in years ago – mainly through laziness and paralysed by indecision.

    What I really dont like about active funds is the lack of transparency in what Im getting charged (and for what!). Like I say, Im not after big returns (although that would be nice), I just dont want to see my savings be eroded by inflation.

    Thanks for the above posts, it has propelled me to be more ‘active’ in the world of passive investing! 🙂

  • 10 dearieme October 3, 2014, 11:51 am

    @Tufty: “I really want to get into passive investing, but I just dont see how it can do better than active investment funds.” Watch the video again. It demonstrates that it’s a mathematical inevitability that £1 invested in passive funds will do better on average than £1 invested in corresponding active funds. This will apply to any market that’s reasonably large, mature, liquid, well studied, and well regulated.

    In fact to beat passive investing you have to find active funds that will do distinctly better than the active fund average AFTER you have bought them. How would you propose to do that?

  • 11 Passive Investor October 3, 2014, 1:10 pm

    @PC – I wasn’t quite clear what your point but if it is a critique of the efficient market hypothesis then why is this necessarily an argument against passive investing? Even accepting that the financial markets are sometimes irrational and not entirely efficient this is a far cry from saying that any individual (let alone a private – read amateur – investor) can beat the market, consistently, without taking on extra risk and after costs. The overwhelming weight of evidence is that active investing is a very poor strategy indeed.

  • 12 Passive Investor October 3, 2014, 2:33 pm

    @PC – case of mistaken identity. I am a private (passive) investor who uses the pseudonym Passive Investor – nothing to do with The Investor who runs Monevator. Can’t quite understand why you think a strategic (risk-based) allocation decision between bonds and equities is the same as active investment based on stock-picking, market timing, or perhaps technical analysis?

  • 13 Passive Investor October 3, 2014, 2:57 pm

    @PC – I didn’t actually say that you were a fan of technical analysis. I was just giving technical analysis as one of the reasons that some people favour active investing. Apologies if it came across differently. I have read the link to your posting which I thought was interesting though I quite strongly disagree with most of it. It deserves a detailed response which I would like to do later when I am near a computer. I’ll post something here if possible. Regards

  • 14 The Investor October 3, 2014, 3:03 pm

    @All — I have deleted Paul’s comments and have my reasons, to do with Internet civility, prior experience, and my time. Put it down to capriciousness if you prefer.

    Paul has a blog where I suppose he will be happy to debate these points with you: http://www.irateinvestment.com/.

    I will also delete any further comments on this matter. I believe I’ve been cordial in giving a link to Paul’s website, so feel free to take it there.

  • 15 The Investor October 3, 2014, 3:23 pm

    @All — Paul has replied to say the discussion can continue on his site. I have deleted that comment because I said I would, as I don’t want other readers to waste time being drawn into a back and forth about this/him that I will then delete, too. Fair warning.

    I thank Paul for his response, and suggest we leave it there.

  • 16 John October 6, 2014, 6:44 pm

    The use of index funds in an individual portfolio is almost becoming mandatory. The more you learn about the benefits the more money you wish you would have contributed. I believe a solid mix of dividend growth investing and index investing will suite the purposes for most investors. Thanks for the article, I enjoyed reading.

    Best wishes

  • 17 StuR October 7, 2014, 4:48 pm

    I’m a little confused – I read Monevator a lot, and it’s always banging on about how nothing active can beat an index over the long term. But there are plenty of Investment Trusts (as highlighted by the likes of John Baron at Investor Chronicles) that regularly DO beat their indexes, often by very large margins, even after costs (which can be as low as 0.5%, which is close to an index tracker). So what’s going on here?

  • 18 grey gym sock October 7, 2014, 9:23 pm

    on investment trusts vs indexes, firstly you need to compare with a suitable index. which is not always easy; e.g. a number ITs are mostly invested in UK companies, but with a few overseas companies thrown in – in which case, you should probably use a blend of the FTSE all-share index and some overseas index.

    secondly, i can think of a couple of factors which have favoured ITs in recent years, but can’t be expected to continue forever. ITs’ discounts have narrowed (boosting their performance), and now stand at historically quite low levels; this could go into reverse (holding back their performance).

    and many ITs are measured against the FTSE all-share index, which is dominated by a few big companies, which have generally underperformed in recent years; ITs have tended to underweight them, which has improved their performance relative to the index. 1 might think this effect could also go into reverse. or 1 might think it will continue – but it doesn’t necessarily follow that 1 is better off using ITs; there are other ways to reduce concentration in big-cap shares, such as combining a FTSE all-share tracker with a FTSE 250 tracker.

    perhaps the main lasting advantage of ITs its their ability to use a (modest amount of) gearing to increase their returns in good times (and decrease them in bad times). though many ITs have used borrowing badly, locking themselves into long-term borrowings a few years ago at rates north of 10%.

    cheaper ITs, with costs around 0.5%, definitely have a better shot at beating indexes. other ITs are more expensive, and some have performance fees on top.

    in summary, cheap ITs, which use gearing sensibly, have a chance of beating indexes. but this is not a very favourable time to buy into most ITs – you want to buy in when there are big discounts. selecting suitable ITs also has to be more difficult than selecting suitable tracker funds.

    a few decades ago, when there were no cheap trackers, ITs were the best game in town – better than actively managed unit trusts / OEICs, which were very expensive because of all the commissions they paid. (active funds are not quite as bad as they used to be, though still a lot more expensive than trackers.)

  • 19 The Investor October 7, 2014, 10:18 pm

    Wow, @greygymsock has done a great job there, just as I was knuckling down to reply. Thank you! 🙂

    One thing I would add is that if we’ve said *no* fund or person will beat the market ever, it was a slip or shorthand.

    Some funds and people will and do beat the market. Some investment trusts have a superb record — and some other funds do too for that matter. Yet researchers still debate whether even this handful of funds achieved their success through luck or skill. And they are the vanishingly small exceptions.

    We have to remember that there are hundreds if not thousands of funds available — I seem to recall a statistic saying there were more funds in the UK than shares in the FTSE All-Share. Which is pretty crazy when you think about it.

    What’s more, they are the survivors in an industry that culls or merges the (many) losers. So most of the funds that fail to beat the market, you don’t even read about today. They were shut down.

    So anyway some of these 1000s of funds/trusts statistically might (and historically have) beaten the various markets. But the task of identifying which will do so in advance is in my view extremely difficult.

    Also it’s really too general to say “investment trusts have beaten the market”. There are investment trusts covering all sorts of sectors. In good times for a particular sector — which is exactly when people tend to be looking at trusts following those sectors — they will often be beating the market because discounts have closed and gearing has kicked in, among other reasons. They may even be trading at a premium.

    All that said I do still have a soft spot for investment trusts. (Remember I — ‘The Investor’ here on Monevator — am not like my co-blogger who is a true passive maven. I fully agree with the logic, but I diverge in practice…)

    In particular I think UK income investment trusts have a solid record, that has stood over many years versus the market last time I looked.

    Even with these though bear in mind the last 20 years has included at least two financial bubbles and blow-outs, and the FTSE 100 is — almost incredibly — still meaningfully below its level in 1999/2000.

    I imagine if the FTSE 100 doubled in the next three years, then some of those income investment trusts records might look a little sickly.

    Arguably that doesn’t matter if you’re buying for income and want some ‘stewardship’ of your money, and don’t care if a more volatile tracker beats you. It’s not always about ‘winning’.

    But that’s different from saying “it’s a good bet that they will beat the market”.

    The reason we keep saying most fund managers don’t beat the market is because statistically they don’t. By some estimates less than 1% do. That’s a 1/100 chance you have there — and you’d be wise not to pick several because it’ll only get harder to keep rolling ‘100’! 😉

    If a journalist comes across the few who do beat the market and flags them up, well, then he or she is just doing their job. 🙂

    As I say, I like ITs as vehicles, and I’ve sometimes pondered whether it’d be fun running one. The several investment trust managers I’ve met have been really engaging people, and the structure is far less pernicious to their investors than say hedge funds.

    Here’s some articles I’ve written on investment trusts in the past if you want to know more:
    http://monevator.com/tag/investment-trusts/

    The bottom line is they’re no silver bullet though.

    I think they’re much better than open-ended funds and for most people they will likely do better with a good long-storied investment trust than picking their own shares.

    But I haven’t seen any evidence that as a group they’re slam dunk winners versus trackers, and I don’t expect to see it, especially on a risk-adjusted basis (i.e. taking in account the discount/premium factor and the gearing).

  • 20 The Investor October 7, 2014, 10:23 pm

    p.s. I’ve just re-read your query and realised you haven’t specified a time frame for beating the market, as cited in by John Barron and so forth.

    Over one or two years, quite a few funds will beat the market. I haven’t got the statistics in front of me, but maybe 40-60% in any year? The funds *are* the market, to some extent, so some will win at the expense of the others.

    It’s over the long-term that trackers prevail. Strong funds tend to slip and laggards catch up, and it’s all-but impossible to know which will do which in advance. And all the time active fund’s higher expenses versus trackers are whittling down their returns.

    Low-cost is therefore a big reason why trackers win over the long-term.

  • 21 Tufty October 8, 2014, 8:51 am

    Very interesting stuff. I think the last 2 paragraphs of The Investor post has clinched it for me.

    So, now that Im a bit more confident that I should be invested in more trackers… you can guess whats coming 🙂 … which would you suggest? Just a couple of suggestions please to point me in the right direction – Im just overwhelmed by choice! All I really know is the Vanguard LifeStrategy (of which Im drip feeding into the 80% one). My current active funds are IP High Income and Neil Woodfoods new fund. As you can see – Im not really diversified! All of this is on the Hargreaves platform – which I think is expensive isnt it? So a recommendation of a decent broker would be great.
    Thanks for all the insights/suggestions/advice.

  • 22 The Investor October 8, 2014, 10:40 am

    @Tufty — You’re asking the right sort of questions! But proper answers are too long and inefficient for these comments. And it’s best to have a proper understanding of why you invest in what you do.

    In short: Reading! 🙂 Start here:

    http://monevator.com/category/investing/passive-investing-investing/

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