That same feeling of wanting to do better than everyone else often pushes people to try and achieve the same with their investment returns as they look to outperform the market on a regular basis. We're not content with being average, we're obsessed with outperforming. At the end of the day, why would you want to just follow an index when that is just a benchmark, surely just the minimal amount, that you would want to obtain? After all, equity indices go down whereas the possibility exists of choosing a fund or individual shares which will hold their own in a downturn and excel in an upturn.
The reality however is that the ability to achieve "superior" returns over a period of time is remarkably difficult, especially for the individual investor, and the potential cost or loss involved in trying to do it could erode away at the necessary capital required in the long term. Many of you who read this will probably tell me that you don't invest in the market, so what difference does this make to you? But this is ignoring the fact that your pension assets will contain mainly equity funds, and it is this long term performance you should be concerned about. As I mentioned in my previous article, understanding finance and how it affects you is now increasingly important.
When planning for the longer term, 15 and 20 years or beyond, investors are going to want to find equity assets to put in their portfolio which are going to grow at a rate which will deliver a comfortable income upon retirement (otherwise known as enabling them to live in the manner to which they've become accustomed). This will lead to the majority of people searching out the equity funds which will perform best and seeking to readjust on a regular basis.
So how do we find these magical funds? Do we look at the funds that seemed to have performed well on a consistent basis for the last 5 years? What about finding funds that have consistently given positive returns for 10 years? Funds focusing on commodity stocks when they're in boom and looking to switch to funds in more "defensive" stocks when required? What about more dynamic funds which will reallocate between different strategies at the fund managers 'insightful' guidance? Picking a winning fund, fund manager or fund strategy in many ways is a lot harder than picking a handful of individual stocks which will grow in the long term. A quick look over many funds performance in searching for funds that will 'outperform' the market or benchmark index consistently over the longer term will turn up very few who have done this for greater than a couple of years. For every example like Neil Woodford's Income Fund at Invesco or Anthony Bolton's UK Special Situation Funds at Fidelity there are hundreds of equity funds who can't consistently beat an index benchmark.
There are many reasons for this failure of more active funds to do their stated aim. But no matter how much information, talent or experience a fund manager may have, consistent outperformance is more difficult. The pressure for fund managers to ensure they at least don't underperform has led to many actually managing their funds as phantom index funds. The need to report constant positive performance on a monthly or quarterly basis to ensure investors don't withdraw their money (and the fund manager doesn't lose his job) lead many to be too afraid to stick with the "long term" strategies they claim to be pursuing. These phantom index funds come at the price to the investor however of paying the cost of investing in an active fund, anything from 1.5% of NAV and upwards annually, a significant cost for a fund which isn't giving you any real outperformance for the additional potential risk involved. There is a genuine lack of visibility over the real strategy followed by many fund managers. Their stated aim may be 'growth', 'value' or 'income' but which stocks or how they're achieving this you are trusting in their ability to constantly pick the right winners with not much visibility over how they are attempting this. You then need to decide, if you've made the wrong choice initially, as to when to pull out of the fund and allocate your resources elsewhere. Is it after your fund choice has "underperformed" for 1,2,3 or even 5 years? Do you chase performance by looking at the top fund performers over the previous couple years potentially engaging in the sell low, buy high strategy that you always told yourself you'd never do? By constantly trying to outperform you may actually find yourself more concerned over your investments and ultimately falling short of your intended targets by trying to reallocate constantly.
As any good investment advisor will inform you, and research has proven, one of the most important things to do in saving or investing for the long term is to ensure you're are putting away enough of your income on a regular basis from an early enough starting point. Increasing the amount of your salary constantly saved much earlier on from a 12% rate to 20% ultimately could lead to an extra 2% a year in market returns over a 20 year period. Concentrating on putting away a sufficient amount consistently earlier on is more important than trying to find those winning funds or stocks which are going to make you rich quickly or help you retire early. Let's be honest with ourselves, getting rich quick isn't how it happens for most people, and attempting to think we're able to pick the funds continuously which will perform the best to get us there quickly is a risky strategy.
To mitigate the added risk that we will consistently underperform the market whilst trying to outperform the market, especially once we take fees into account, it begins to make sense to aim to be the market. Instead of risking constant underperformance, investing in index tracker funds is a safer way over the longer term to attempt to get the long term returns required. Whilst this form of investing may not have the exciting aspect of constantly trying to pick potential winners, it is this precise passiveness around the strategy which should bring more comfort in your investment decision. Of course we should never make an investment decision because it is easy to follow, but if the time, knowledge and, let's be honest, lack of foresight is missing then this becomes a perfect strategy for those looking only to the long term. Others around you might be seeing higher returns in both the short and long term, but an equal number around you will also be financially worse off through constantly reshuffling. It's the advantage of getting the average return that is the market. Meanwhile the relatively smaller fees in comparison associated with these funds is also a big bonus. Rather than the 1.5% and above of active funds, these index trackers will have a fee charged of between 0.3% and 1%, depending on the fund and index. That's potentially at least 1.2% extra returns per year for you as an investor compared to active funds. To think about that in context, if the underlying level of your fund remained constant for both the active and index funds, the value of your investment would drop 11.37% more over 10 years, and 21.45% more over 20 years, by investing in an active fund. So even if you have chosen active funds who are outperforming the market, they would need to do so by over 21.45% over a 20 year period before fees to make it worth your while.
Over the last 20 years the FTSE 100 has returned 118.96% and the S&P 500 314.38% before taking dividends into account, or 4% and 7.4% annually before dividends respectively. This would show historically you would need an annual return every year on your active UK equity fund of 5.2% and active US fund of 8.6% just to match the price return on indices. This is before taking dividends into account. The approximate average annual dividend yield on the FTSE 100 was 2.92% over this same period pushing up the required rate of return on your active UK equity fund to 8.12% (assuming the lower level 1.5% annual fee) and this is just to keep pace with the "average" market performance. Looking at these figures it does suddenly begin to raise questions as to whether the majority of active funds can justify the fees charged over the long term.
None of these statistics are of course to say that pure equity index investing is a risk free strategy. As with all investments, there is no such thing as a free lunch (in some cases there is, but generally not for the regular retail investor and I've not got the time to go into that here). A quick look over the last 15 years will see at least 2 occasions where equity market indices have plummeted, losing over 40% of value post 1999 only to rebound back to similar levels followed by a crash of equal proportions and further recovery in more recent times. Looking at the FTSE 100 over this period specifically will show that it is still yet to reach the same high level reached in 1999, whilst the S&P 500 has shown only a price return of 51% in that time. The broader FTSE All-Share index has returned just 24%. This though fails to include dividends and the impact of reinvesting them, whilst it also looks at a simplified approach of investing an amount solely at the start of the period. It also highlights the difference to your returns depending on which index to track and poses the question about how best to allocate your investment between indices. Meanwhile by investing with someone who actively manages the fund, they in theory should be trying to insulate themselves against the large market falls which just putting your money in index funds will expose you to.
While all of these are valid reasons as to the potential "perils" of index investing, I believe the benefits are still better than trying to use active funds for superior return. Selecting the correct active funds, for example, which might insulate you in times of a falling market, may come at the cost of substantial fees and also at failing to give you the full benefits of a rising market. You might argue that you could only use these, or switch to cash, in a falling market, but then you are exposing yourself to trying to guess as and when to time the market peaks and troughs which research has shown investors tend to get hideously wrong. The better approach is, as mentioned earlier, making regular contributions (monthly if possible) to your investments from the start. This can make a massive difference in boosting your returns ensuring that you are still buying into the market when it is at the bottom and rising again getting more benefit immediately from a rising market.
It is also important to remember that while the equity index number we all focus on is what's quoted on the media, both now and historically, those numbers only represent the price return and so don't account for the impact of dividends on return. Investing in index funds who reinvest the dividends received results in exposure to the total return of the index. When you take this into account, the fact that the concern that the headline index level hasn't risen much from it's peak becomes less of an issue. The FTSE 100 Total Return Index (includes dividends) has more than doubled since January 2002, versus only a 30.7% increase in the quoted FTSE 100, while the FTSE All-Share Total Return Index shows a 121% return over the period (6.8% annually) versus 44.3% for the headline rate. (Unfortunately data for Total Return Indices is a lot more scarce and only available from 2002).
Of course, as with any investment product, the caveat emptor principle always exists. Some indices never recover, even with dividends, back to their peaks for decades, or potentially ever. The Nasdaq, from a price perspective, still sits 23.5% below it's March 2000 peak, but this is more as a result of it being a tech heavy index still shrugging off the dotcom exuberance and collapse. Meanwhile Japan's Nikkei 225 peaked at 38,957 back in December 1989. It's level at the close this morning was 14,042, down 64% nearly 25 years later. Japan too though must be taken into context, with the Nikkei 225 rising uncontrollably by 224% in just under 5 years to 1989 in response to a similar appreciation in Tokyo property prices. This unsustainable property bubble and subsequent severe collapse, following large interest rate hikes by the Bank of Japan, led to an equity market crash in 1990-91 from which Japan is yet to recover. Whilst we may be seeing a spiraling London property bubble at the moment, it is by no means comparable to that seen by Tokyo in the 1980's. In addition, the existing Bank of England governer Mark Carney seems reluctant to use interest rates as the tool to calm it down, preferring other less severe measures, seemingly learning from the BoJs mistakes. Meanwhile the effect of house price rises on UK equity markets is much less pronounced. Both the FTSE 100 and FTSE All-Share are much more affected by more global conditions given the international nature of many of the firms which make them up.
All of this leads me to believe that, for most investors looking to grow their savings and pension pots for the longer term, index investing is the best step forward. From the substantially lower fees and growth benefits once dividend reinvestment is considered, to the reduction in the risk of constantly trying to chase the winners, the pros for me far outweigh the arguments against. There is still the difficult choice to be made of what percentage to allocate to which domestic and foreign indices, which could still impact your returns substantially, but on this the individual needs to decide. Of most importance is the need for the investor to constantly be investing, whether in a pension, ISA or both, from as early an opportunity as possible and as regularly as possible. This is what will both boost long term returns and ensure money is invested at the bottom as well as the top. It may not be as exciting as constantly seeking the best fund managers or stock market stars, but this is one of the times in life where getting by on being average will work just fine.
While all of these are valid reasons as to the potential "perils" of index investing, I believe the benefits are still better than trying to use active funds for superior return. Selecting the correct active funds, for example, which might insulate you in times of a falling market, may come at the cost of substantial fees and also at failing to give you the full benefits of a rising market. You might argue that you could only use these, or switch to cash, in a falling market, but then you are exposing yourself to trying to guess as and when to time the market peaks and troughs which research has shown investors tend to get hideously wrong. The better approach is, as mentioned earlier, making regular contributions (monthly if possible) to your investments from the start. This can make a massive difference in boosting your returns ensuring that you are still buying into the market when it is at the bottom and rising again getting more benefit immediately from a rising market.
It is also important to remember that while the equity index number we all focus on is what's quoted on the media, both now and historically, those numbers only represent the price return and so don't account for the impact of dividends on return. Investing in index funds who reinvest the dividends received results in exposure to the total return of the index. When you take this into account, the fact that the concern that the headline index level hasn't risen much from it's peak becomes less of an issue. The FTSE 100 Total Return Index (includes dividends) has more than doubled since January 2002, versus only a 30.7% increase in the quoted FTSE 100, while the FTSE All-Share Total Return Index shows a 121% return over the period (6.8% annually) versus 44.3% for the headline rate. (Unfortunately data for Total Return Indices is a lot more scarce and only available from 2002).
Of course, as with any investment product, the caveat emptor principle always exists. Some indices never recover, even with dividends, back to their peaks for decades, or potentially ever. The Nasdaq, from a price perspective, still sits 23.5% below it's March 2000 peak, but this is more as a result of it being a tech heavy index still shrugging off the dotcom exuberance and collapse. Meanwhile Japan's Nikkei 225 peaked at 38,957 back in December 1989. It's level at the close this morning was 14,042, down 64% nearly 25 years later. Japan too though must be taken into context, with the Nikkei 225 rising uncontrollably by 224% in just under 5 years to 1989 in response to a similar appreciation in Tokyo property prices. This unsustainable property bubble and subsequent severe collapse, following large interest rate hikes by the Bank of Japan, led to an equity market crash in 1990-91 from which Japan is yet to recover. Whilst we may be seeing a spiraling London property bubble at the moment, it is by no means comparable to that seen by Tokyo in the 1980's. In addition, the existing Bank of England governer Mark Carney seems reluctant to use interest rates as the tool to calm it down, preferring other less severe measures, seemingly learning from the BoJs mistakes. Meanwhile the effect of house price rises on UK equity markets is much less pronounced. Both the FTSE 100 and FTSE All-Share are much more affected by more global conditions given the international nature of many of the firms which make them up.
All of this leads me to believe that, for most investors looking to grow their savings and pension pots for the longer term, index investing is the best step forward. From the substantially lower fees and growth benefits once dividend reinvestment is considered, to the reduction in the risk of constantly trying to chase the winners, the pros for me far outweigh the arguments against. There is still the difficult choice to be made of what percentage to allocate to which domestic and foreign indices, which could still impact your returns substantially, but on this the individual needs to decide. Of most importance is the need for the investor to constantly be investing, whether in a pension, ISA or both, from as early an opportunity as possible and as regularly as possible. This is what will both boost long term returns and ensure money is invested at the bottom as well as the top. It may not be as exciting as constantly seeking the best fund managers or stock market stars, but this is one of the times in life where getting by on being average will work just fine.
