Many friends and clients tell me they want to start investing in the sharemarket, but have no idea where to start. BHP shares are looking cheap, shall I start by buying some of them? My financial adviser recommended I put some money in an AMP managed fund – what do you think? My stockbroker said he could set me up with a small portfolio of 3-5 blue chip shares…
My simple response is why don’t you just do what the world’s most successful investor recommends?
The World’s Most Successful Investor
What does the world’s most successful investor recommend when it comes to investing? Billionaire Warren Buffet, and Chairman of Berkshire Hathaway has said “A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money”. Warren Buffet has also instructed the trustees of his estate when he dies to :
“Put 10% of the cash in short-term government bonds and 90% in a very low cost S&P500 index fund… I believe the trust’s long term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
As discussed below, no matter how much money you have to invest, by investing in an index fund, you immediately have a diversified investment portfolio – be it a small shareholding in each of the top 200 Australian companies or a small shareholding in some of the 500 largest companies in the USA.
Active Managed Funds and Index Funds
An actively managed fund is a fund that employs a team of analysts to “actively” manage the funds under investment by attempting to select stocks that will outperform a benchmark index. Due to the cost of employing their team of analysts to find “winners”, and high commissions to financial advisers, the active fund manager charges a higher annual management fee relative to an index fund. But due to the skill of the fund manager, the marketing spin is that the fund will outperform the benchmark index, even after their management fees.
An index fund is an investment fund that endeavours to match the performance of a benchmark index. Most index funds work by building a fund that owns shares in all or the majority of the assets that make up the relevant index, and in the same or similar proportions as the index. As the index fund manager does not seek to outperform the index or pick stock winners, the management fees of the index fund are generally much lower than an actively managed fund.
Typical benchmark indices include :
- S&P500 : An index representing the market capitalisation of 500 of the largest companies listed on the New York Stock Exchange and NASDAQ in the United States of America
- ASX200 : An index representing the market capitalisation of the largest 200 companies listed on the Australian Stock Exchange). Index funds are not just limited to share indexes, but you can have index funds that for example seek to track the performance of bonds or a subset of a broader share market (eg. Resources).
- MSCI World Index : An index of over 1600 listed stocks around the world. It is used as a common benchmark for world or global share funds, and includes a collection of shares from all the developed markets in the world (23 countries), but excludes emerging economies.
What is the relative performance of active vs index funds?
While it might not seem logical, many studies have now shown that due to (a) the difficulty in consistently identifying shares that will outperform the market average, and (b) the additional management fees charged by actively managed funds, there are only a limited number of actively managed funds that will beat their benchmark index over an extended period of time. And you probably have better odds of picking the winner of the Melbourne Cup, than knowing which fund manager is likely to beat the benchmark index over a long term timeframe.
In addition, it should be noted that actively managed funds continuously churn their shareholdings (ie. buy and sell shares) and thereby realising capital gains on their investments. As a result, the after tax returns of actively managed funds are further reduced compared to index funds (due to their buy and hold approach).
In 2014, Forbes published an article “3 to 1 Odds Favor Index Investors” (http://www.forbes.com/sites/rickferri/2014/03/24/3-to-1-odds-favor-index-investors/) which stated “On average, over a five year period, about 25% of actively managed mutual funds will outperform their benchmark, 25% of funds will underperform by a small amount, 25% will underperform by a large amount, and 25% won’t make it the entire five years.” The problem is identifying which 25% will outperform for the given five year period, and then recognising that the same fund is unlikely to continue to outperform for the subsequent five year period.
In the June 2015 Active/Passive Barometer report from funds research company – Morningstar, the report finds that “actively managed funds have generally underperformed their passive [index] counterparts, especially over longer time horizons and experienced high mortality rates (i.e. many are merged or closed). In addition, the report finds that failure tended to be positively correlated with fees (i.e. higher cost funds were more likely to underperform or be shuttered or merged away and lower-cost funds were likelier to survive and enjoyed greater odds of success). Fees matter. They are one of the only reliable predictors of success.”
How to invest in an index fund?
If you want to invest in an index fund there are a couple of choices
- (Unlisted) Retail Index Fund
A retail index fund is based on the traditional concept of managed funds. You send / transfer your money to the fund manager, and when the fund manager receives your money they purchase units in the index fund for you at the prevailing price at close of business on that day. If or when you want to sell the units in your index fund, you notify the fund manager and your units will be sold at the prevailing price at close of business on that day. As far as I am aware there is only one major retail index fund manager in Australia – Vanguard Investments. The only downside is you do need $5000 minimum investment and, if you don’t already have an existing account, opening an account from overseas is difficult.
Your alternative to investing in an unlisted index fund in Australia is to invest in an unlisted index fund in your country of residence. As an example, click here to see what countries Vanguard offers index fund options.
- (Listed) Exchange Traded Funds
The other alternative (and my preferred approach) is to invest in an Exchange Traded Fund. An exchange traded fund (ETF) is essentially an index fund that can be bought and sold on the sharemarket like any other share. The advantages of investing in an ETF are that you can trade them freely at any time and know exactly what price you will receive for your shares. ETF’s are traded on the Australian Stock Exchange (and others). To invest in an ETF requires you to have a share trading account. If you do not already have an account, it is possible to open a share trading account with an online broker (such as E-Trade or Commonwealth Securities) while overseas. The exact requirements for opening an account will depend on whether you have an existing relationship with the company and where in the world you are living.
For more information on Exchange Traded Funds, go to my article Why Australian Expats Should Consider Investing in Exchange Traded Funds.
Disclaimer : This information is for educational purposes only and does not constitute financial or taxation advice. As this information is not advice and has been prepared without taking into account your objectives, financial situation or needs you should, before acting on this information, consider its appropriateness for your circumstances. Independent advice should be obtained from an Australian financial services licensee before making investment decisions, and a registered (tax) financial advisor/accountant in relation to taxation decisions. To the extent permitted by law, we exclude all liability for any loss or damage arising in any way.
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