When You're Investing, Simple Can Be Smart

Posted by E.A. Mann on February 26
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When the average person pictures an investment fund manager and their associates, I imagine they see a team of people shouting “Sell! Buy!” into a telephone on a busy trading floor.

This scene isn’t quite accurate in its details, but this type of investment still exists: it’s called an actively managed fund. A savvy investment manager, along with a support team, crunches data and tries to pick a winning mix of custom investments. As a consumer, you can purchase shares in this fund. If the managers pick well, the fund rises and you gain.

On the other side of the divide are passively managed funds. These funds set some rules and passively follow those rules.

The most well-known type of passive fund is called an index fund. An index fund simply tracks an investment index that already exists. For example, the FTSE 100 is simply a list of the top 100 companies in the U.K. A FTSE index fund consists of shares of those companies. Consumers can buy these funds as well. There are employees who manage index funds, but there is no “expertise” at play.

So one type of fund requires a team of people, an assured manager and years of market experience. The other requires no smarts and minimal work. Which one is better? You’d have to imagine that the actively managed funds win out, year after year.

But in general, you’d be wrong. Very wrong.

There is a fascinating web site called SPIVA, which stands for S&P Indices Versus Active management (S&P create a popular U.S. stock index). It compiles historical data for both actively and passively-managed funds and compares them. The implications of the data are mind-blowing.

According to SPIVA, in all of Europe over a five-year period, 74.3% of active managers underperformed (read: did worse than) an index fund of 350 European companies. Only 1 out of 4 could beat the index fund.

The SPIVA website is very detailed, so you can review all kinds of different market segments: specific countries, large companies, small companies only, etc. But with rare exception, the story is the same: over a five-year period, the index investments crush them all.

But what about the 1 out of 4 active managers who beat the indices? You should just invest in those funds, right?

If only it were that easy.

As the consumer, you have two problems. First, you don’t know ahead of time which funds are going to beat the indices. Unfortunately, the fund that beats the indices for the past five years may not beat it for five more. And two, those active funds are much more expensive than the index funds, often ten-times as expensive or more. The fees make even those winning funds less attractive.

The SPIVA website has a treasure trove of data, and a lot of it is nuanced. So I don’t want to paint with an overly broad brush. There are some small segments of the market where smart people can outperform indices, and if you’re a savvy investor, you should consider them in narrow cases.

But I’m writing this for the general investor, someone with a non-finance job who just wants to invest their extra pounds and see them grow. And to that person, I say: stick with the index funds. Find the lowest fees. Make sure you diversify. Five years on, you’re likely to be better off.

Pick the simple investment - it’s the smart move.

Photo - Rene Böhmer

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Written by E.A. Mann

E.A. Mann is a systems engineer and freelancer who specialises in finance writing. He is passionate about breaking down complex investing concepts so that everyone can understand them, not just the experts.

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