Index trackers

For most private investors, the best way to invest in stocks and shares is to buy index trackers.

Private investors who do not have the time or inclination to study several investment books and research shares in depth do not have the slightest chance of beating the market over the long term using their talent, intuition, etc for selecting individual shares or by investing on the basis of tips. They would be better off betting on the races or engaging in similar gambling pursuits where they would at least know the odds and get the results quickly.

Even most professional investors are unable to beat the market other than for a few years and that too by chance only, in the same manner as flipping a genuine coin can result in a series of heads or tails though each flip has an equal chance of being a head or a tail. Many years ago, professional investors could beat the market because they were buying and selling from private investors who still had shares that accounted for a significant proportion of the market capitalisation. Also market transparency was low and insider trading was rampant. But as the holdings of the private investors decreased and professional investors holdings became most of the market capitalisation and market transparency and insider trading rules were implemented (albeit with a lot still to be desired), professional investors found it very difficult to beat the market because they became the market. It became a zero sum game for them because for every purchase and sale, the counter party was another professional investor and all such investors received share price moving information simultaneously from the company. The markets dominated by professional investors with equal access to information became much more efficient and it became very difficult to find mispriced shares. That is why, of the hundreds of actively managed collective investments, only a tiny proportion of professional investors can boast a record of outperforming the indices in the long run. And it is impossible to know who that tiny proportion are and invest in the collective investments managed by them because they can be identified only in hindsight.

According to an article dated 20 March 2016 in the Financial Times under the headline "86% of active equity funds underperform", an in-depth analysis of the performance after fees of 25,000 active funds by S&P Dow Jones Indices shows:

1. Almost every actively managed equity fund in Europe investing in global, emerging and US markets has failed to beat its benchmark over the past decade

2. Overall in Europe, four out of five active equity funds failed to beat their benchmark over the past five years, rising to 86 per cent over the past decade

3. 98.9 per cent of US equity funds underperformed over the past 10 years, 97 per cent of emerging market funds and 97.8 per cent of global equity funds.

4. The majority of UK large and mid-cap funds beat their benchmark over one, three and five years. Over 10 years, however, all UK fund categories underperformed.

Numerous other studies also confirm the under performance of actively managed funds compared to index trackers; the longer the comparison period, the greater the under performance.

In 2008 Warren Buffett bet a million dollars against Ted Seides (a leading hedge fund manager) that an index fund would beat hedge funds chosen by Seides. The cumulative returns of the index fund chosen by Buffett was 125.8% compared to 36.3% for the hedge funds chosen by Seides.

Index tracking investments are of two types:

1. Open ended funds (unit trusts, collective investments, mutual funds, oeics) that are priced once a day by the funds and bought from or sold to the funds direct or through brokers. When buying these, check that the tracking error is insignificant and then select the one that has the lowest total expense ratio (TER). You will find this information easily at the respective web sites.

2. Exchange traded funds that are traded on stock exchanges and are priced by the market at all times while markets are open and bought and sold through brokers. When selecting an exchange traded fund check the spreads at different times in the day - they can be quite wide for some ETFs. Avoid trading at close to the opening and closing times as the price may not reflect the underlying value closely. Also, stay clear of synthetic ETFs, inverse ETFs and leveraged ETFs. Stick to ETFs that replicate the performance of an index by purchasing a weighted package of all or most of its constituent securities.

Rather than try to pick index trackers that track specific regions, countries, sectors, investment style, etc, pick an index tracker that tracks a global index like the FTSE All World Index or the MSCI All Country World Index.

Watch  Lars Kroijer's video for more on this.

Even the few investors who can boast track records of beating the index in the long run and the academics who have made rigorous studies of the performance of fund managers, advise private investors to invest in index funds rather than try to beat the market by stock or unit / investment trusts picking:

John C Bogle

• Experience confirms that buying the right stocks, betting on the right investment style, and picking the right money manager - in each case, in advance - is like looking for a needle in a haystack. When we do so, we rely largely on past performance, ignoring the fact that what worked yesterday seldom works tomorrow. Investing in equities entails four risks: stock risk, style risk, manager risk, and market risk. The first three of these risks can easily be eliminated, simply by owning the entire stock market - owning the haystack, as it were - and holding it forever. Yes, stock market risk remains, and it is quite large enough, thank you. So why pile those other three risks on top of it? If you’re not certain you’re right (and who can be?), diversify. Owning the entire stock market is the ultimate diversifier. If you can’t find the needle, buy the haystack.

Warren Buffett

• Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific business nevertheless believes it is in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.

• Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

• Stocks are the things to own over time. Productivity will increase and stocks will increase with it. There are only a few things you can do wrong. One is to buy or sell at the wrong time. Paying high fees is the other way to get killed. The best way to avoid both of these is to buy a low-cost index fund, and buy it over time. Be greedy when others are fearful and fearful when others are greedy, but don't think that you can outsmart the market. Very few people should be active investors.

• What advice would you give to someone who is not a professional investor? Where should they put their money? Well, if they’re not going to be an active investor— and very few should try to do that— then they should just stay with index funds. Any low-cost index fund. And they should buy it over time. They’re not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock. You just make sure you own a piece of American business, and you don’t buy all at one time. 

• The goal of the non-professional should not be to pick winners — neither he nor his “helpers” can do that — but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.

• The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

Burton Malkiel

• The message of the original edition was a very simple one: investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds. Now over 35 years later (in 2007), I believe even more strongly in the original thesis. An investor with $10,000 at the start of 1969 who invested in Standard & Poor’s 500-Stock Index Fund would have a portfolio worth $422,000 by 2006, assuming that all dividends were reinvested. A second investor who instead purchased shares in the average actively managed fund would have seen his investment grow to $284,000.

• Even Benjamin Graham came to the conclusion that fundamental security analysis could no longer be counted on to produce superior investment returns. Shortly before he died in 1976, he was quoted in an interview in the Financial Analysts Journal as follows: I am no longer an advocate of elaborate techniques of security analysis in order to find superior values opportunities. This was a rewarding activity, say, 40 years ago, when Graham and Dodd was first published; but the situation has changed, . . . [Today] I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost. . . . I'm on the side of the ''efficient market'' school of thought. Peter Lynch, just after he retired from managing the Magellan Fund as well as the legendary Warren Buffet, admit that most investors would he better off in an index fund rather than investing in an actively managed equity mutual fund.

Benjamin Graham

• Since anyone - by just buying and holding a representative list - can equal the performance of the market averages, it would seem a comparatively simple matter to "beat the averages"; but as a matter of fact the proportion of smart people who try this and fail is surprisingly large. Even the majority of the investment funds, with all their experienced personnel, have not performed so well over the years as has the general market.

• Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. This figure is sufficient to provide a very real margin of safety - which, under favourable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favourable result under "fairly normal conditions" becomes very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them an adequate margin of safety. The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying nonrepresentative common stocks that carry more than average risk of diminished earning power.

• I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity years ago when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors.

Ben Warwick

• Market sectors vary in how quickly they respond to information. Large cap U.S. stocks, for example, are followed by so many analysts and reflect company fundamentals so quickly, that it is nearly impossible to add value through active strategies. I recommend indexing such sectors.

Robert H Jeffrey

• To the extent that the market is mostly efficient, we can expect only modest improvements in portfolio returns from active asset management.

Bruce Sherman

• [A client] asks if we can recommend a large-cap manager for him. I said, I’m going to save you some money. Don’t buy a manager, buy the index.

Merton Miller

• I favour passive investing for most investors because markets are amazingly successful devices for incorporating information into stock prices.

Richard H Thaler

• Few investors, including professionals, beat the market. You are unlikely to be one of the lucky ones. Most strategies to beat the market involve having either better information or making better use of that information. Neither approach is likely to work for an amateur. Why should your information be better than the information available to mutual fund managers who may have hundreds of analysts at their disposal?

William Sharpe

• Active management is something to do with your "mad money".

Rex Sinquefield

• Peter Tanous describing Sinquefield's approach: Thus active management is a waste of time. You are far better off spending your time, energy and money deciding what types of stocks you want to buy and then buying those index funds that correspond to the types of stocks that you have chosen.

• There have been loads of scientific studies looking for evidence that can tell successful managers based on their prior records. These studies do not meet with success. There is no reliable evidence that there is persistence in professional manager performance.