Most Monevator readers know high costs are the major reason to avoid active funds, and that low costs are the biggest draw for index trackers.

However paying high fees to managers – as well as all the trading and other expenses racked up by an active fund – wouldn’t matter if they soundly beat the market.

Around here we tend to think of passive investing and index tracker funds as a ménage à deux, but there are plenty of people who invest in active funds who would describe themselves as ‘passive’ investors, too.

They simply put their money into a variety of actively managed funds, and then leave them to get on with trying to beat the market.

But sadly, the reality is few active funds do beat the market after costs, as explained in this Sensible Investing video:

It’s the failure of nearly all active funds to beat index trackers over the long-term that makes active versus passive such an unfair fight.

Imagine an alternate reality where, say, 40% of active funds beat the market.

Or maybe where 50% of funds beat the market – but with more volatility, or with fatter ‘tails’ that meant some active funds lost most of your money, but a good proportion spanked trackers.

Then we’d have a really interesting debate on our hands.

But as Jack Bogle, the father of index funds, says:

“The intellectual basis for indexing is is gross return minus cost equals net return. Period. What is the intellectual basis for active management? I’ve never heard one.

“Probably about 1% of managers can beat the market over the very long term.”

I wouldn’t call 1/100 anything but exceptionally long odds. Would you?

Are there any good reasons to invest in an active fund?

So as it is, there’s not really any reason to invest in active funds unless:

1) Your sister is a fund manager.

2) Your brother-in-law is a fund manager.

3) You like the romance and colour of active fund management, and you’re happy to pay for it and do worse overall.

4) You want to beat the market and you don’t care that the odds are hugely against you, and you don’t want to pick shares for yourself.

I paraphrase, but that’s the gist.

Now, occasionally a reader will voice a comment saying “it doesn’t have to be either/or”.

And I agree. (Heck, I pick shares for my sins so I can’t be precious).

However you have to be really clear about why you’re investing in active as well as tracker funds.

• If you want to juice up your returns, then investing passively in value and other so-called return premiums might do the trick.

• If you’re doing it to reduce volatility, then it’d almost certainly be safer and cheaper just to hold fewer equities and more cash and bonds.

• If you’re doing it to get overseas exposure, well, you can easily do that through ETFs and trackers.

• Some people claim they own active funds for the diversification, which makes little sense given the huge diversification offered by trackers – except to add the few hard-to-reach areas of the market like UK small caps.

Holding 10 active fund managers who invest in UK, US and European large caps is to my mind simply an expensive way of getting tracker-like performance at best, but doing worse after costs.

It doesn’t help that a growing share of active funds are closet trackers to start with.

How I’d invest in active funds

I believe the only reasons for investing in most active funds1 is either because you’ve a sentimental attachment to them (I’m not being facetious – many managers write great narratives about their ultimately fruitless decisions) or because you want to try to beat the market despite the poor chances.

If it’s the latter – and you don’t want to pick shares yourself, and return premiums don’t do it for you – then be smart about how attempt it.

How I’d probably try to go about it is to decide on my one or two very highest conviction active fund ideas (no mean feat, given academics have shown past performance is no clue to future performance) and then invest only in those one or two funds for my active allocation.

I’d then make up the bulk (say 80%) of my equity portfolio with tracker funds.

This way you get a little bit of active fund management colour if you want it, and if they beat the market then you will.

But most of your portfolio will remain pretty cheap, thanks to the trackers, and they’ll likely keep your returns in the same ballpark as the market, too.

Think of your modest allocation to active funds as an indulgence or a folly, like having a pot-bellied pig as a pet.

A bit of fun perhaps, but completely unnecessary, and probably more expensive than you think.

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

1. As opposed to active stockpicking, which is challenging and fun and my own foible. [↩]

I know so many busy people for whom a pension is yet another itch to scratch. The guilt and fear is palpable. Even thinking about trying to save the money is agony – an unbearable imposition that threatens to bring down their house of cards.

Behavioural economist Shlomo Benartzi has an explanation for this. His Save More Tomorrow programme offers one possible pension saving solution that won’t rub up your cerebellum up the wrong way:

Save More Tomorrow is not commonly practiced in the UK, however, so it’s time to get our own plan – one that’s better than sticking a large wodge on a rank outsider at Chepstow racecourse when you hit age 65.

Following on from my reader-inspired research into financially challenged investing, I wanted to track down the cheapest pension available to someone who can only dream of shoestrings.

Important: If your employer will match your pension contributions in a company-run scheme, then you should probably snatch its hand off. To not take that money is like handing back a chunk of your salary every month!

Dirt cheap SIPP

Assuming you want a DIY pension scheme, then it needs to be a flexible, low cost vehicle that can put you on the right track while accommodating small contributions.

We’re looking for the cheapest pension that delivers:

• Low fees: Church mice can ill-afford to lose cheese to charges.

• Low cost index funds: Passive investing offers the opportunity to earn market returns, mostly unmolested by fees.

• Fund choice: Enough to create a diversified portfolio.

The cheapest DIY pension I’ve found is the Best Invest Select SIPP if your pension is worth less than £59,000 and the Interactive Investor SIPP if it’s worth over £59,000.

The Best Invest SIPP offers:

• No set up fee.

• No dealing fee for Unit Trust / OEIC funds.

• A market-clobbering platform charge of 0.3% of your assets per year.

• No switching fee (an industry standard, but still good to know).

Note: I’m not factoring in any charges incurred here when you start to take your pension. The world could look very different on that day, so it would amount to speculation.

Mind your fees and Qs

The percentage fee platform charge is very important for an investor with a small amount of assets.

A 0.3% nibble of £10,000 will cost you £30 per year, in comparison to the £176 flat-rate charge you’d pay to Interactive Investor.

Percentage fees turn into a real burden as you amass wealth, however. Best Invest’s 0.3% would cost you £177 annually, if your SIPP was worth £59,000.

Meanwhile Interactive Investor would still be charging you a flat-rate of £176, no matter how much you’d stashed away with them.

So as you approach the £59,000 mark, consider switching to Interactive Investor if you can restrict your trading to twice a month and can take full advantage of II’s trading cost rebate feature.

Once your SIPP is up and running, you can then pick a low cost index fund portfolio from the SIPP’s fund list, diversified along the lines of the Monevator Pound Stretcher portfolio or The Slow and Steady portfolio.

Use this recipe and the only extra fees gnawing at your future will be the relatively low Total Expense Ratios (TERs) of your funds.

You’ll be hard pressed to run a tighter ship than this.

The bare minimum

The sticking point with the Best Invest SIPP is its minimum contributions:

• £2,880 lump sum to set up the SIPP (tax relief is added on top).

• £80 minimum per fund (tax relief is added on top).

On the face of things, those minimum contributions are pretty high hurdles. If they look too daunting, then a stakeholder pension can be yours for no more than £20.

Bear in mind though that assuming you can find the required lump sum, you can thereafter top-up your funds in bite-size chunks. There’s no need to pay in £80 per fund every month. You could save a smaller amount, and buy a fund when you can afford it – perhaps feeding into one fund per quarter.

I’d start off with a low cost World or International index fund (Vanguard and Fidelity have very competitive offerings) and then diversify into a gilt index fund, adding further cheap trackers (for example a FTSE All-Share fund) as you build up your assets.

Our brassic paradigm means you’ll have to shy away from the wallet-bashing fees associated with the other investments you might otherwise pop into your SIPP, such as ETFs, investment trusts, individual shares, gold bullion et al.

Ready, aim, retire!

So you have it. If you’re living on beans at the moment and you don’t want to spend your old age the same way, then choose the cheapest pension you can, get cracking, and let compound interest put the wind in your saving sails.

Take it steady,

The Accumulator

Note: We updated this article with brand new facts and figures on cheap DIY pensions in September 2014, so reader comments on the article may refer to the old, outmoded copy of yesteryear. Get hip to the new words, Daddy-o!

Good reads from around the Web.

Even as passive investing in index funds stealthily takes over the investing world, the media and many investing professionals still seem in denial, if not downright hostile.

Perhaps I shouldn’t complain.

Every Saturday morning I review the investing links I’ve found in the previous 6-7 days that have any relevance to UK readers. Often – like today – the passive haul is about as bountiful as you’d get if you drift-netted the Dead Sea.

For now at least, the role for Monevator on the Web seems intact. That’s personally reassuring given seven years of Saturday morning link-compilations and all the writing we do in-between, but I’m not sure it’s good for investors.

For example, one UK blogger said the only place he saw the news that Vanguard had cut its charges on UK ETFs was here on Monevator.

He wasn’t right about that, a quick Google Search reveals. It’s true though that the news wasn’t exactly flashed in lights. The Telegraph even managed to find a negative spin, with a headline warning of a catch. Platform charges could be a sting in the tail, the article went on.

Fair enough, but why is that headline news when it’s equally true of all funds?

Up denial river

It has been interesting watching the criticisms of passive investing evolve over the years since the idea was introduced by John Bogle in the 1970s.

First it was ridiculed, and then decried as unworkable.

When index trackers proved totally workable, detractors started championing the superiority of active managers – even as the threat of passive funds and the difficulty of consistently beating a benchmark turned many of them into closet trackers.

Becoming desperate, some have called passive investing “un-American”. Presumably the idea is it’s better to reach for glory and fail – in the spirit of the American Dream – than to settle for average. Rather like a beautiful young person who goes to Hollywood to become a star and ends up a stripper and in later life a bag packer at Walmart. At least they lived their dream, right?

Actually, I have some sympathy for that view when it comes to business, art, sport, and becoming the next Isaac Newton.

However I don’t believe many young people’s burning ambition is to enrich the financial services industry by paying high charges.

Another tack that’s been gaining ground this year has been to simply declare the active versus passive debate ‘boring’.

I admit that hurts, though I suppose we’re biased here on Monevator.

If anyone is an indexing trainspotter it’s my co-blogger, and I know that some of you would be happy to stand beside him at passive investing’s metaphorical Clapham Junction.

When you’re wrong, even when you’re right

Another new tack was taken this week, in a rather strange article from Cullen Roche at Pragmatic Capitalism.

Roche constructs what’s in my opinion a straw man argument that says passive investing must – by his definition – involve buying the global market exactly as you find it, with the same weighting towards equities and bonds.

He then argues that since this is impossible, passive investing (by his definition) is impossible, and adds that those of us who advocate passive investing likely “don’t understand there is no such thing.”

He presents no evidence for the latter point, he just declares it.

Roche also implies that anyone who did passively invest to exactly mirror the global market – again, his definition of passive investing, remember, which he has already implicitly conceded nobody does because he’s already told us it’s impossible – would basically be an idiot, because sometimes assets prove to be overvalued.

He cites a few active managers who took a stand about some asset or another and were right and says that’s why they’re on a pedestal.

“What’s rational about being overweight bonds after the biggest bull market in history?” he asks.

I don’t know, most passive portfolios don’t advocate that so I’ve never looked into it. Only his phantasmagorical version does.

Theory versus reality

I am in no way personally attacking Roche here, just the thrust of this piece. In fact I’ve linked to other articles of his in the past, and if you ignore the screeds about “this ‘passive’ investing ideology”, you might find even this article a thought-provoking read.

It’s that tone I don’t get. I really don’t understand why he’s running around in circles to lambast something that he’s just invented as a problem.

I also disagree with his implication that since some managers could do better than the passive approach, passive investing has a big weakness as a strategy.

That isn’t the point. The reality is vanishingly few managers do better, even if the efficient market hypothesis leaves sufficient room to make outperformance possible.

Given that, why should investors choose active funds if they want the best chance of appropriate returns?

There’s no logic. They are not investing to support careers in the financial services industry, or to play some great game of finding a needle in a haystack. They just want the best odds of a decent return.

You see this time and time again. Fund managers and platform spokespeople saying passive investing is all very well, but some manager beat the benchmark last year or last decade or whenever, so choose them.

It’s a fallacy if what you’re after is the likeliest shot at near-market returns.

Know what you’re doing and why

None of this is to say I am against investing in active funds if you’re prepared to do worse for a chance to do better.

Equally, I am right behind you if you want to stock pick your own portfolio.

I do, and for now I wouldn’t have it any other way. That’s the great irony of this website (and why my co-blogger writes most of the passive articles!)

But my personal preferences are no argument against passive investing. Nor is a complaint about the word ‘passive’, nor is the fact that one in a 100 fund managers (or one in 50 or one in a 1,000 – it really makes no difference to the logic unless it were one in two or so) beats the market for long enough for it not to be a fluke.

[continue reading…]