We all know there is no such thing as a free lunch but when it comes to investing, diversification is the closest thing to it. But the cost of investing in 50, 200 or 1,000s of companies individually is prohibitively expensive. This is where managed funds come into play. You can combine your money with others and pay an ''expert'' to manage the money for you.
If the fund manager you choose is an ''active'' manager of your money they are likely to be investing in 20-80 stocks and may be turning over 80% or more of the portfolio each year (turning over means selling companies and buying others). This level of active management incurs high transaction costs and often results in a significantly worse after tax result as any investment sold within a 12 month period is not eligible for the 50% discount that assets held for longer than 12 months are.
To make matters worse, active managers often charge 1.5% - 2.00% or more for actively managing the fund. In some cases they also charge a performance based fee in the case they outperform certain criteria.
To rub salt into sore wounds caused by the high fees, the returns achieved by active managers, particularly after fees and taxes, are on average lower than the benchmark index returns.
Research from Australian Prudential Regulation Authority (APRA) casts further doubt on the benefits of using active investment managers. The APRA research shows that the extra fees charged by active super fund managers result in significant underperformance, compared to lower cost passive (index) funds.
APRA analysed the investment performance of 115 superannuation fund managers over the period 2002 to 2006. The conclusion drawn was that ''…higher management expenses leads to poorer net investment performance of the firms … value adding from active management appears statistically to be unable to overcome higher costs associated with attempts to exploit market inefficiencies...''.
Index funds on the other hand can provide broad access to a portfolio of securities representing a particular market or segment of a market. As the APRA research emphasises, index funds have low trading volumes, low trading costs, low capital gains tax cost and limited individual stock research requirements. All these factors result in overall lower costs combined with market linked returns.
Drawback of Index Funds
Whilst index funds provide great diversification at low cost, they have a few drawbacks. For example, index funds are not readily tradable throughout the day. To purchase or redeem an investment in an index fund the fund manager needs to process a transaction request that is based on an end of day valuation.
Another drawback of index funds is the buy/sell spread or the difference between what you can sell the units for versus the price you can buy them for on the same day.
Exchange Traded Funds
An Exchange Traded Fund (ETF) just might be the answer to some of the drawbacks of Index Funds. Exchange Traded Funds (ETFs) are indexed funds which are listed on the Australian stock exchange.
ETFs were first introduced in 1989. They have since become one of the fastest growing investment products in the world. In 2008 ETFs were one of the most traded investment instruments in the US and by 2012 assets under management worldwide are expect to be $2 trillion (Robyn Laidlaw of Vanguard).
ETFs trade like any other share. When you make a single purchase you are buying a broadly diversified portfolio. Depending on the EFT you purchase you could gain exposure to the 50 largest or 200 largest Australian companies or a range of other local and international indexes.
An Exchange Traded Fund can be traded throughout the day as it is listed on an exchange (Australian Stock Exchange for example). Being able to trade the fund throughout the day not only gives the investor more control to buy and sell at particular prices but also eliminates the buy/sell spread because trading on an exchange involves aligning a buyer and a seller to agree on a transaction price.
In terms of the cost of Index funds versus ETFs, Vanguards ASX300 index fund has an Investment Management Fee of between 0.35% to 0.75% p.a. depending on the amount invested. Whereas the equivalent ETF has a fee of 0.27% p.a. However with the ETF you also need to factor in the brokerage fees.
When buying or selling an ETF, rather than paying a buy/sell spread you pay brokerage fees. If you choose a discount online broker the brokerage fees could be as little as $30. This is a low price if you are purchasing larger parcels of shares but is not so good if you are regularly investing small amounts as even a $30 fee could eat into your overall performance. If you wish to regularly invest small amounts (called dollar cost averaging) it is usually better to stick with index funds rather than Exchange Traded Funds.
At the time of writing the ASX 200 index (Australia’s 200 largest companies) was trading at 4700 up from 3100 on 6 March 2009 but still well below the previous high of 6800 on 1st November 2009.
This presents an opportunity to invest in the broad index, take advantage of the unique opportunity to ride the wave back up to (and beyond) the previous high of 6800 on the ASX200. Using an index fund or an exchange traded fund will enable to you ride that wave at low cost, with lower risk than a managed fund and well diversified.
When it comes to investing, diversification is the closest thing to a free lunch. Depending on your circumstances Exchange Traded Funds could be the best method eating that free lunch.
Some further food for thought…
''The business schools reward difficult complex behaviour more than simple behaviour, but simple behaviour is more effective.'' (Warren Buffett)
''Send your grain across the seas, and in time, profits will flow back to you. But divide your investments among many places, for you do not know what risks might lie ahead.'' (Ecclesiastes 11:1 & 2 (New Living Translation))
''Don’t put all of your eggs in one basket!''
Business
Exchange Traded Funds…the closest thing to a free lunch
By: Gavin Martin
Christian Today Australia Columnist
Christian Today Australia Columnist
Thursday, 8 October 2009, 16:05 (EST)
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