Investment: Simplicity and low costs are key to success
Every pound spent on marketing a mutual fund or unit trust has to come from somewhere, and ultimately it is the investor who picks up the bill
Wednesday 19 May 1999
Just as it did in the 1960s, this has created an appetite for equity investment which is fast becoming something of a perpetual motion machine, with new money chasing past performance in a seemingly endless circle of self-reinforcing conviction. The marketing muscle of the collective fund business, which is many times that of the direct share ownership lobby, has ensured that most of the money that has flowed into the stock market has been through funds of one kind or another.
But another reason is simply the fact that owning funds is the most efficient way for most investors to gain rapid exposure to a diversified stock market portfolio. Ultimately, the mutual fund/unit trust model is a success because it provides something investors both need and can benefit from.
But saying that collective investment funds are the most efficient way of gaining diversified stock market exposure is not the same as saying they are necessarily as perfect as they could be.
While most investors should not turn their backs on fund investment - it is clearly the optimal equity savings vehicle for most people - they should make sure they get the best value for money out of the successful formula that mutual funds/unit trusts represent.
As regular readers will know, in my view funds are often too expensive for what they provide, are far too busy trading shares and are not always a tax efficient medium. That is why a low cost tracker fund (with the emphasis on the low cost element) should be at the core of most people's portfolios and the benchmark against which they test the performance of any actively managed funds that they own.
Nobody has done more to spell out the realities of successful fund investing than Jack Bogle, the founder of the Vanguard Group, the American fund management company that was profiled in this section a couple of weeks ago.
Bogle has now put his experiences in a book, due out here shortly. While Common Sense on Mutual Funds is primarily directed at a US audience, there is nothing in it that does not apply in some measure to the UK fund industry.
Needless to say, Bogle makes a powerful case for sticking with the index phenomenon, and effectively demolishes most of the self-serving arguments deployed against it by the active management lobby. Just as interesting are his criticisms of the fund management industry for what he regards as its failure to take its fiduciary responsibilities to investors as seriously as it takes its commitment to winning new business.
He believes the business today is typified by the old expression: "We used to be a business that sells what it makes but we have become a business that makes what it sells."
His evidence is powerful and impressive, even if it stems in part from the self-interested desire to promote the company he founded. His argument is that the massive attention to marketing, while a natural consequence of the fund industry's fee structure, creates dangers for those investing in the funds they market so assiduously.
What are these dangers? First, and most obviously, says Bogle, every pound spent on marketing a mutual fund or unit trust has to come from somewhere - and ultimately it is the investor who picks up the bill. Secondly, as fund performance tends to deteriorate the bigger a fund becomes, the industry's relentless drive to grow assets under management tends inevitably to dampen returns. One symptom of this is that few funds are closed to investors until they are well past the point where their returns can reasonably be expected to start reverting to the mean.
Thirdly, there is a tendency for successful funds to be over-hyped. The way that funds are sold, usually on the basis of recent performance, is liable to mislead investors about the potential returns they can expect.
Finally, and most importantly, Bogle says the marketing focus subtly changes the nature of the relationship between the investor and his fund. In his words: "Rather than being perceived as the owner of the fund, the shareholder is perceived as a mere customer of the adviser. At that point the mutual fund is no longer primarily an investment account under the stewardship of an investment manger, but an investment product under the control of a professional marketer".
Does this sound familiar?Whether you look at UK unit trusts, investment trusts of life funds, it is impossible to look back over the past five years without coming across numerous examples of the problems that arise when fund management companies' interests come into conflict with those of the investors in their funds. The more successful fund management has become as a business, so too has the potential conflict of interest grown too.
What can investors do about it? Quite a lot. Apart from looking at index funds, the smart investor could do worse than follow Bogle's eight rules for simple fund investment: 1: Stick to low cost funds wherever possible. 2: Be wary of hidden costs of investment advice. 3: Don't put too much emphasis on past fund performance, except (rule 4) as a means of distinguishing a fund's risk profile and consistency. 5: Beware of any rating system based on stars. 6: Beware of large funds. 7: Don't own too many funds: five is usually enough. 8: Try to stick with the funds you have. There is nothing to be gained by chopping and changing and little to be gained by adding layers of diversification that add to the costs you incur.
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