Index linked funds

 

I was recently asked in a comment on the site whether using indexed funds would be a good investment strategy.  These are funds (unit trusts, mutual funds, etc.) that buy shares in companies that make up the market index.  That means that the index fund follows the index (whether it is the UK “Footsie”, a US or Far East Market or a specialist area like technology). 

 

I’m not going to suggest particular funds, you need a good IFA for that.  But in general, if you’re going into the stock market, indexed funds are a good plan.  That’s partly because they tend to be cheaper (you don’t have to pay for lots of research and management, the fund buys the shares and that’s it – so you aren’t paying for lots of swapping around that the managers do to try to “beat the index”).

 

There’s a couple of other things about index funds.

 

One is that they tend to help you to avoid trying to predict what the market is going to do.  If, for example, you think that oil stock is going to rise then you might try to buy lots of oil stock.  Or if a managed fund manager things that technology stock is a “good buy”, they may get lots of technology companies.  That works well if you guess right.  You buy everything that is going up.  You gain on the swings and on the roundabouts.  But of course, if you get it wrong (if the Far East market goes down because there is an earthquake, or oil stocks drop because of political unrest) then you lose on the roundabouts and on the swings.

 

Since people can’t predict the future accurately, that is a bit of “all the eggs in one basket”.  So it seems to make sense to buy a range of investments (such as all those in the index), so that if some go down, others will possibly go up and what you lose on the swings, you gain on the roundabouts. 

 

It is human nature to think that you (or your fund manager) are, like Jose Mourinho, “the special one”, that you can predict the future, beat the experts, outperform the index etc.  But the evidence is that you can’t.

 

The second point is regarding index linked performance itself – in comparison to actively managed funds and direct share investment.  There was an analysis of lots of studies a few years ago (by Werner De Bondt, who is a leading academic in the field of behavioural finance).  This indicated that index funds outperform 75% of actively managed funds over virtually any time period.  And half of the remaining 25% of managed funds only outperformed their relevant index by chance.  This also ignores the many failed funds.  That is relevant because companies often fold up unsuccessful funds, or merge one fund into another.  That way, they can wipe out their really obvious mistakes and pretend that they are doing better than they are.

 

So you might do better with direct shares or with actively managed funds.  But you probably won’t. 

As a final comment on this point, if you want a master investor as a role model, you need look no further than one of the richest men in the world, Warren Buffet.

 

“Most investors, both institutional and individual, will find that the best way to own common stocks [shares] is through an index fund that charges minimal fees.  Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals.”

 

Warren Buffett—Berkshire Hathaway Annual Report, 1996.

 

If you know somebody who is a better investor than Mr. Buffet, please let me know.  If you don’t, I’d generally follow his advice!

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