There are alternative ways to invest in stock markets and avoid expensive, often underperforming actively managed funds
Fund managers are some of the highest-paid people in the City, regularly raking in £1m-plus salaries, yet fewer than four in 10 "actively managed" funds beat the market index over a 10-year period. However, there are alternatives that enable you to match the performance of almost any index, at a significantly lower cost than giving your money to a Porsche-driving stockpicker. The good news is that it's not just cheaper to invest in index funds, it's easy too. Just follow our 10-point guide to investing on the cheap.
1 What is an index?
The FTSE 100 index is made up of the biggest 100 companies on the UK stock market. The index began in January 1984 at a base level of 1,000, rose to a peak of 6950.6 on 30 December 1999 and this week was trading around 6650. If you invest in an index, you are investing a tiny part of your money in each company in the index. There are now thousands of indices covering virtually every market in the world.
2 What is an index fund?
Index tracker funds buy the same shares as an index, in the same proportions, and so mimic its performance. A tracker fund uses computer programmes to do the buying and selling, cutting out pricey fund managers.
There are two ways to invest in an index; either through a conventional unit-trust style tracker fund (the first was launched in the US in 1974) or through exchange-traded funds (ETFs) which began life in 1993. There are pros and cons for both. Most can also be placed in a tax-free Isa wrapper.
3 Why buy an index fund?
Just one reason: price. A conventional actively managed fund on average gobbles up 2.5% of your money every year, while an index fund can be found for just 0.2% a year.
On the surface, the fund management industry tells investors they will pay an initial fee (up to 5% of your cash gone straightaway, but often discounted down to zero with a bit of shopping around) plus 1.5% of your investment every year. Typically 0.75% goes to the fund manager annually, another 0.5% to the person who sold it to you and about 0.25% to the platform that holds and administrates the fund for you.
But in truth, it's much worse than that, because fund managers don't disclose turnover fees upfront. That's the cost of actually buying and selling shares in a portfolio, which adds, on average, another 0.9% a year. Throw in auditor and trustee fees, and the real cost of buying an active fund is about 2.5%, year in, year out.
These charges massively reduce your returns. Research from consumer group Which? shows that if you invested £10,000 in a fund with no charges, and it grew by 6% annually for 20 years, you'd get a return of £32,071 – just over £22,000 growth. If you invested in a fund with fees totalling 2.5% a year, you'd be paying out £12,000 in charges.
Index funds and ETFs typically charge just a fraction of traditional fund management fees, with the cheapest (such as those from Vanguard and Fidelity) at about 0.2% a year.
However, some index funds are surprisingly pricey; Virgin UK Index Tracking, which has more than £2bn under management, has an annual fee of 1%, and trackers sold by Halifax and M&S are also expensive.
4 How do I buy an index fund or an ETF?
Fund supermarkets are the best place to start. These are platforms on which investors can manage investment Isas, funds and pensions all in one place. Index funds used to be unpopular to the companies that run these platforms as they don't pay commission, but investor pressure has forced them to be made available. Try i.nvest at alliancetrustsavings.co.uk, Hargreaves Lansdown at hl.co.uk, Fidelity's fund supermarket at fidelity.co.uk or Cavendish Online at cavendishonline.co.uk
ETFs are more like individual shares and you buy them through share dealers, such as Barclays, Halifax and TD Direct, but many are also available on the fund platforms. Note that you will pay dealing fees and other admin costs.
5 Which index tracker should I choose?
First decide which market you want to be in – UK, Europe, US, emerging markets and so on.
Indexing tends to work better in big, developed markets but can be expensive if you want to track indices in less developed, illiquid markets.
Vanguard is the giant in index investing, offering both funds and ETFs, with Fidelity making a major push into the market.
6 Which is cheapest for tracking the FTSE?
Fees change regularly in what is a very competitive market, but this is a selection of the best:
• Vanguard FTSE 100 ETF. Fee: 0.1%. Buy at TDDirectInvesting.co.uk on a standard dealing charge of £15 plus a quarterly admin fee of £15. If you invest over £15,000, the fees are waived so you only pay the 0.1%.
• SWIP Foundation Growth. Tracks the FTSE All-Share. Fee: 0.1%. Only available at Hargreaves Lansdown, which adds a £2 monthly fee. If you are investing less than £15,000, this is a good option.
• HSBC FTSE 100 Index Fund. Fee: 0.17%. If you buy at HSBC's Global Investment Centre, there is a 0.39% account fee on top. Buy at Cavendish Online for a total of 0.35%.
• Fidelity Moneybuilder UK Index. Tracks the FTSE All-Share. Fee: 0.3%. No additional charges if you invest at Fidelity.co.uk.
7 Which is cheapest for tracking global markets?
• To invest across the world, try Vanguard Life Strategy 80%. It is a pack of index funds covering UK, US, emerging markets and bonds, and is one of the best-selling funds on i.nvest. Fee: annual 0.32% plus 0.24% initial.
• To invest in the US, try Fidelity Moneybuilder US Index Tracker. Fee 0.3%. No additional charges if you invest at Fidelity.co.uk.
• For Europe try iShares Euro Stoxx Total Market Value Large ETF. Tracks large companies in European markets. Fee: 0.4%.
8 Which are better – index funds or ETFs?
There's not a lot between them, apart from the fact that ETFs are listed on a stock exchange, like shares, and can be traded any time the market is open. Proponents of ETFs claim they are more transparent, liquid and flexible than traditional funds, and are often cheaper. What's undoubtedly true is that ETFs enable you to track not just equity indices but a wide range of other things, such as gold and oil, all the way through to agricultural commodities.
But there are worries about synthetic ETFs which do not physically buy the underlying stocks but use a derivative instead. Critics, such as Terry Smith of fundsmith.co.uk, claim they are full of "unappreciated risks".
9 What if it all goes wrong?
If the stock market falls, bad luck. There's no compensation scheme that protects small investors from shares going down in price. But the Financial Services Compensation Scheme does cover you for the first £50,000 if the firm you invest through defaults.
10 Is a tracker for me?
They make sense as a cheap, core holding for any investor, so long as you follow some basic rules: diversify your investments, hold for the long term and drip-feed in your money through regular savings.
Seeking advice? No-obligation investment advice is available from Guardian Investing, provided by Skipton Financial Services. If you have any longer-term financial aspirations but are unsure of how to achieve them, it could pay off to obtain personal financial advice. Visit
guardianinvesting.co.uk
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