Part 5: Why We Love Index Tracking Funds

Many people invest solely in funds.

Funds are all types investment vehicles that predominantly invest in shares. Some of them may invest in a particular industry, country or region whilst others will invest in the whole market.

Funds also responsible for most of the colourful adverts in the weekend newspapers. How can they afford such expensive advertising, you might be thinking?

The answer is quite simple – they charge high fees. Existing investors in the fund are in essence paying for the marketing expenditure. It’s a nice trick, if you can get away with it, which they seem to do, but hopefully not for too much longer!

The two basic types of funds

Funds can be split into two basic types. There are ‘active’ or ‘managed’ funds where the fund manager picks and chooses the shares on your behalf, getting paid handsomely for the privilege we might add.

Then there are ‘passive’ funds that merely buy the whole market or a certain section of it. These are known as index trackers because they attempt to track an index. An index measures the overall performance of a group of companies, such as the S&P/ASX 200 (the 200 largest shares on the Australian Securities Exchange).

The ‘active’ vs ‘passive’ debate

Active investing sounds much more fun doesn’t it? We all want to beat the market.

By definition, before we take charges into account, half of our investment will do better than the overall market and the other half won’t. When you take off charges and transaction cost, you can see it’s inevitable that most funds will underperform the market. We put that in bold, because we think it’s rather important.

Standard & Poor’s Index Versus Active Funds Scorecard: Australia Mid-Year 2010 confirmed the view, saying…

Over the five-year period ending June 30 2010, a majority of active funds across most of the peer groups in this study have failed to beat their respective benchmarks.

Charges matter a lot. So, if most actively managed funds underperform the market, and they charge higher fees, why would anyone choose to invest in them?

The Dirty Little Secret

That’s why we’re here. It’s the dirty little secret “the industry” doesn’t want you to know. But we’re Fools (with a capital F). We tell the truth. There are no secrets here.

What this all means is that, most people are better choosing a fund with low charges. And passive funds have the lowest charges. They are run by computers and computers tend to be a lot cheaper to run than fund managers. They don’t eat, drink, drive fast cars, have to pay a mortgage or send their kids to posh schools.

We’re talking index tracking funds.

Of course, there will always be some funds that do better than index trackers. The only trouble is identifying them in advance. Some people claim they can, although it’s a lot more difficult than you might think. For one thing, oodles of research has shown that the past performance of a fund is no guide to its future performance.

For your first investment though, you want to keep things both simple and cheap — and we thinks that means some sort of index tracker. So, begone managed funds!

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