It's dumb vs smart in clash of the funds

The Motley Fool guides you through the personal finance maze


Simple index-tracking individual savings acc- ount (ISA) usually has low charges while closely following the market average. On the other hand, a self-select ISA gives you total control and allows you to choose your own shares. Which is best? This week, we consider the two sides of the argument in our Duelling Fools ISA special.

Simple index-tracking individual savings acc- ount (ISA) usually has low charges while closely following the market average. On the other hand, a self-select ISA gives you total control and allows you to choose your own shares. Which is best? This week, we consider the two sides of the argument in our Duelling Fools ISA special.

 

The tracker case

Simple access to the stock market and low charges - that's what most people want from a stocks and shares ISA. Easy regular investments and flexible access to your money are bonuses, too. In short, you need a cheap, flexible product that's simple to understand and saves you tax.

There are two options. You could buy an index-tracking fund. Or you could go for an actively managed investment, buying individual shares within a self-select ISA, or investing in a managed fund.

The second route will surely prove more complicated and more expensive. Professional money managers don't come cheap, charging high fees for looking after your cash.

In addition, if you pick the actively managed path, you no longer have the security that comes with matching the index. You could beat the market, but you're just as likely not to. Very few professional fund managers actually beat the index consistently. Are you confident that you can do it?

Most of us tend to overestimate our stock-picking abilities. If it goes down, it's bad luck; if it goes up, it's skill. Putting the bulk of your long-term investment into the market average via a tracker ISA will provide you with a lower-risk investment, and is a good way to use up your ISA allowance. You can, of course, still flirt with higher-risk shares, with a small portion of your money outside an ISA if you want.

There are short-term downsides to a tracker, of course. When the index falls, as it did in 2000, tracker funds fall. But for around a century now, the stock market has been doing very nicely indeed, long term.

 

The self-select case

For many people who don't have the time to pick their own shares, an index tracker is a good choice for an ISA. But there is a strong argument for using a self-select ISA to protect your investments and get a better performance.

The self-select route enables you to avoid being part of the "dumb money" that goes into shares irrespective of valuation. For example, if you had put your £7,000 ISA allowance into an index tracker in June last year, at least 10 per cent of it would have gone into Vodafone. Vodafone is a fine company but do you want £700 or more of your money going into a loss-making business, then valued at 26 times sales, in an industry subject to regulatory control? Vodafone shares have since fallen a long way and have helped pull the FTSE 100 down by over 10 per cent.

The problem with index trackers is that you are obliged to invest in the highest-flying shares in the index whether you like it or not. But there is more to it than that. Avoiding the rigidity of an index tracker allows you to use your own expertise to pick individual shares or specialised funds. You'll want to avoid risk, of course (like not paying too much for Vodafone, for example). So why not look for low-risk shares that offer the prospect of reasonable returns without too much downside?

Remember the Japanese Nikkei stock market index? Last week it touched a 15-year low. Would you want a tracker invested in an index like that?

* Tracker or self-select? The Motley Fool ISA centre at www. fool.co.uk can help you to decide.

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