Investing has been on peoples agendas for many years. This is one of the paths that people choose to build up their retirement pot. And when it comes to picking the best investment strategy – not many will outperform an index fund.
Index funds have proven to be secure companions of most long term investors. There are many reasons and benefits to putting your money into an index fund. While these might not be the most exciting types of investments – they do their job and do it well!
I will give my take on what index funds are below. I will also try to explain the key benefits of these and why in the long run they often outperform the actively managed funds.
what is an index fund
Index funds are a type of investment that tend to mimic or track a financial market. Some examples of these can be the world famous S&P500, UK’s biggest index – FTSE 100 or any other major or minor market.
Many companies offer investors to buy a share of their exchange traded funds (or ETFs for short). There is a list of benefits to these such as low management costs which makes these perfect candidates to invest your money into for later in life.
If you decide to hold index funds as part of your portfolio – there are some great news for you. These can be held inside your ISA account making these not only cheap to hold but also tax free when it comes to taking out the profits.
how index funds work
As mentioned above – index funds are trying to mimic a financial market. A portfolio manager will try to buy ratios of shares as identical to the total market as possible. This will then be left to grow and perform.
While there is a portfolio manager looking after this – his or her involvement in the actual performance will be minimal. The most these people normally do is rebalance the portfolio if needed as well as sell or add any companies that are changing within the market itself.
Due to minimalistic inputs required – this type of fund can be considered passively managed.
When it comes to replicating the market – index fund managers will look at both the companies that form the financial market as well as the ratios these are held in. Normally the ratios will be linked to the size of the business in terms of its market value.
why choose index fund as your primary investment vehicle
There are a few good reason to consider passive index funds over actively managed ones. Most of these reasons will be linked to the returns that you can expect from the passive option.
Due to index tracking being a simplistic model of investing – the costs that investment companies charge are minimalistic. These can go as low as 0.15%. The flip side to this are the actively managed funds that can easily charge you 1-1.5% per year.
While the difference between the two doesn’t seem that big – the results from both can be significantly different over longer period of time.
If you were to invest £500 per month for 30 years and both portfolios would return 10% (9% for actively managed due to higher costs) – the results will shock you. Passively managed index fund would be worth £1,140,000. The actively managed one would be worth £922,000.
Is it really worth paying £200,000 for someone to actively manage your money?
The reason actively managed funds charge a higher fee is due to there being larger teams of professionals to look after these portfolios, frequent selling and buying requires fees and taxes to be paid. And surprise – all of these fees are always passed on to the investor.
how do index funds perform compared to actively manages ones
You will most likely say – there is a reason to pay for an active fund manager. The returns he or she will generate will be significantly above any passive index fund.
Unfortunately, that isn’t always as straight forward as that. You will be right that some fund managers will manage to outperform the market. The majority however won’t be able to achieve this.
To add to the insult above that it would cost you £200,000 over the life of your investments for someone to manage your funds – the odds of this person actually to do better than the market are only 25%. 3 in 4 active fund managers actually end up underperforming the market in the long run.
You might have heard of Warren Buffett? If you haven’t – he is just the most famous investor of all times. Back in 2007 he made his world famous bet – he bet $1,000,000 that hedge funds would not outperform S&P500 over the period of 10 year.
Guess what – that $1 million got paid into his already $100 billion worth account by a hedge fund manager who accepted the bet. Obviously, the winnings ended up being transferred to a charity. The point that Warren Buffett wanted to make – highlight the extremely high costs that most fund managers charge.
Additional point to make – those few fund managers that manage to outperform an index fund will often struggle to replicate this performance in the long run. And as such, the moment you manage to find an investment fund that had a run of delivering better results than an index – the odds of this continuing are not in your favour.
summary
If you are looking to invest for the long run – you should not look beyond a passive fund that tracks one of the major indexes.
The strategy of buying and holding has proven itself as an effective way of making money in the long run. Most of the times it also allows you to outperform majority of investment specialists and gurus.
One further advice to give – look at the fees that the platform that you use charges. These will add up over the long run and end up costing you dearly.