ETF or managed fund: What should I put inside my Isa?

Ian Peacock
Why do even super-star managers underperform? (Source: Getty)

The main benefit of investing in an active fund managed by a “star” manager is supposed to be getting a superior return to simply tracking an index. However, research from Cass Business School shows that the majority of active fund managers fail to beat the index once fees have been deducted from returns.

In fact, just 1 per cent of fund managers are genuinely “stars”, in that they are able to generate a superior performance above operating and trading costs over several years, the Cass research showed. Even these star performers then take a large amount of the superior performance for themselves in fees and associated costs. That leaves little for the investor. In 2015, according to Morningstar, over two thirds of managed funds underperformed their benchmark index. Index funds, by contrast, seek to track the market whether it is rising or falling and have much lower associated costs.

How can this happen, even with superstar managers?

A number of reasons. First, to generate superior performance a manager will often focus on a few, fairly large trades when compared to a fund tracking an index that invests in a large number of stocks – and the active fund will therefore be less diversified. If these trades do not pay off, by definition the manager’s portfolio will be underweight in names that may be the winning companies in an index. This effect is amplified in a bull or rising market.

Second, bigger is not always better. Large funds tend to underperform smaller funds in certain markets. This makes sense because, as larger funds scale up existing investments or buy holdings in greater size, capacity issues might arise and the manager might simply not be able to implement all the bets he or she would like to.

Third, the fees charged by managed funds have a material impact without even factoring in the platform fee of the provider. Typically, actively managed funds buying stocks charge an average total expense ratio of approximately 1.2 per cent to cover manager fees, dealing commissions and required services. If you add to this a typical platform fee from the adviser, the cost comes to 1.65 per cent. On a typical return of 5 per cent a year, this leaves only 3.35 per cent of net return to the investor.

Consider one of the most popular exchanged-traded funds (ETF), the iShares Core FTSE 100 UCITS ETF. It has a total expense ratio of just 0.07 per cent. If it were bought within the IG Stocks and Shares Isa before the end of April 2016, it would not incur any dealing or platform fees. The same 5 per cent market performance would return something in the range of 4.93 per cent net to the investor. That’s almost a 50 per cent improvement on the managed fund.

Most ETFs track an index but have the trading characteristics of a share, as they are traded throughout the day on a stock exchange. Virtually any index you can imagine is available via an ETF, and over 1,000 are eligible to be traded in a stocks and shares Isa.

The transparency, flexibility and low cost of ETFs make them an ideal building block for creating a diversified investment portfolio. If investors believe their active fund manager is failing to outperform the index by a significant amount, they should seriously consider switching some or all of their investments into ETFs. Investors are already starting to become aware of the benefits of ETFs, which have seen 24 months of consecutive net inflows, in large part at the expense of actively managed funds.

We believe the market for ETFs is set for explosive growth in the UK and predict it will reach £50bn in assets by 2020. ETFs are truly one of the most exciting investment opportunities of our generation.

Ian Peacock is head of UK and Ireland at IG Group. Your capital is at risk. Tax laws may change.

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