Although trackers never match their chosen index exactly (there is always a difference of tracker error and fees), they do offer consistency. And even with the small percentage lag, if you assume the (widely-held) view that the stock market will grow over the medium- to long-term, a fund that tracks the market can be a fairly reliable bet, as far as investments go.
Managed funds, where an individual chooses the shares in the fund basket, are a bit different. While they can offer greater rewards than a fund that merely tracks the average, they can also deliver steeper losses. In fact, over the long term, nine out of 10 managed fail to beat the index. In shorter-term windows, managed funds tend to look less impressive than trackers, but when you look at the long term, the situation is reversed.
Why trackers beat managed funds, year after year
One of the main reasons trackers outperform managed funds is lower charges. Trackers don’t need fund managers to make decisions on what to buy and sell: they just follow the market. When you consider initial charges (typically up to 5% for managed funds; not applicable to trackers) and annual management charges (around 1.5% for managed funds; 1% or less for trackers), you can see how trackers can manage to cost less. Factor in that managed funds tend to incur more dealing charges due to buying and selling more frequently, and you can see how trackers cost less.
Here’s an example: you invest £1,000 in a managed fund and £1,000 in a tracker, and both investments deliver a return of 11% per year. But you don’t get this whole 11% -- your tracker charges 1% each year, which knocks your returns back to 10%. With your managed fund, the initial charge and the typically higher annual charge come to 2.5%, which means this investment only delivers an 8.5% return.
Over 10 years, the managed fund would be worth £2,261 compared to the tracker’s £2,594, and over 20 years just £5,112 compared to the tracker’s £6,728 -- a huge 24% difference in return.
Recent seismic changes in the financial landscape have had a devastating effect on the stock market, but historical evidence tells us that over periods of five or more years, shares tend to do better than cash. So even with the events of 2008 in mind, if you are investing for the long term, the stock market -- and more specifically, an index tracker -- looks like a good bet.
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