Two simple ways to invest better in shares

If you're looking for the best way to invest your SIPP or your ISA, there are two simple ways to do so that you can be confident will outperform most fund managers and private investors over 25 years or more.

If you’re looking for the best way to invest your SIPP or your ISA, then you should be aware that the vast majority of managed investment funds underperform the stock market. That’s right: most fund managers can’t even beat their own benchmark.

This stands to reason. Together, these funds mostly are the stock market and the market can’t, on average, outperform itself. Now, deduct the cost of these funds from the stock-market’s performance and, on average, funds have underperformed.

Two easy alternatives

There is no way to invest that is cost free, but there are two ways to reduce costs and thus be supremely confident of beating the majority of managed funds. These are ‘index trackers’ or ‘exchange-traded funds’ (ETFs). Both of these have no managers; they simply track the market using computers. Thus, the charges typically range between 0.3% and 1%, whereas you’re more likely to pay 1.5% with a managed fund.

This may not seem significant, but small differences matter. A lot.

Look at this:

Your gains on £100 invested every month

These figures assume everyone gets an average 6%pa, which is not to say that I think that’s what will happen!

As you can see, the difference is quite staggering. ½ a percent extra in fees can make you £4,000 worse off after 25 years and more than £18,000 worse off after 40. It’s easy to see why most managed funds don’t do so well with this massive handicap!

The best way to cut these fees is with index trackers and ETFs.

Index trackers

Index trackers are funds that either use your premiums to buy all the shares in a specified index, or they just simulate the action of buying all the shares. You might track the FTSE 100 or FTSE All-Share indices, both of which measure the performance of the UK stockmarket, or an exotic one like a Pacifix Index, which tracks Asian countries, excluding Japan, but plus Australia.

These funds very closely follow the performance of their index. However, they don’t match it precisely. This is partly due to fees. Although fees tend to be much lower than managed funds, they still have an impact. Another factor is what’s called ‘tracking error’, which means how much the tracker deviates from the index. This is caused by how trackers invest (which can be quite complex) and by some other costs that don’t show up in the fees.

When you choose a tracker, you want to ensure that the tracking error is small over at least the past five years, and you want to go for the lowest possible charges. Thankfully, you can see both the tracking error and the ‘total expense ratio’ (which is the annual-management fee plus some other costs) in the ‘Simplified Prospectus’ document.

ETFs

ETFs are relatively new, but they have proven very useful. They’re so great that they’ve quickly become the most popular investment that the financial industry itself buys (which doesn’t say much for what they think about their fund-management teams, on the whole).

ETFs are listed on the stock market like shares. Each share you buy in an ETF owns a small part of the index its tracking, so if you buy a share in a FTSE 100 ETF, for example, it holds tiny shares of each of the UK’s biggest companies.

One feature of ETFs is that you can trade them very quickly through your broker. I’ve deliberately used the word ‘feature’ and not ‘benefit’. For most of us, the best thing we can do is not take advantage of that feature. On average, the more we trade the worse our investments perform, because we have to pay charges to both buy and sell – and these charges add up very quickly! It’s better for most of us to just hold on to ETFs (and trackers) until we have to sell them or it’s time to cash them in. These are not really for trading. Not for us.

Lots of choices

Related how-to guide

Make money from the stock market

Taking the plunge into the stock market isn't for the faint-hearted, but investing can help you achieve your financial goals.

See the guide

You don’t have to buy the UK, as there are hundreds of indices to choose from, and it certainly makes sense to spread your risks, perhaps by having a basket of four to eight funds, mixing both developed and emerging markets.

I have no strong preference for either index trackers or ETFs, and I invest in both.

Other stuff

Through ETFs, you can invest in commodities, ‘leveraged’ funds and ‘short’ funds. All of these are much higher risk and you must really, really know what you’re doing. If you’re reading this, I think it’s safe to say you don’t.

There are now also some index trackers and ETFs called ‘fundamental trackers’ which are very interesting but, whilst some of them may prove fantastic over the long run, the data is limited. I would say again that they are not for people who don’t have the time and knowledge to look after them, and they’re not for people who just want to buy and forget, which means its not suitable for the audience I’m targeting here.

How to invest in these funds

To invest in ETFs you can open a share-dealing account, or a shares ISA, or even a self-invested personal pension (SIPP).

You can invest in index trackers through some shares ISA or a private pension (including many SIPPs).

All of these types of account have great tax advantages except for the share-dealing account, where you’ll be liable to capital-gains tax, and will be taxed on any dividends you receive. (Dividends are company profits paid directly to shareholders.)

This is a simplified guide, but we’re talking about simple products here. Whilst no fund is perfect, trackers and ETFs are an excellent way for people who don’t have the knowledge and judgement to choose individual shares or managed funds, nor the huge amount of time and the temperament it requires to maintain a portfolio effectively.

Smart investors should be happy to sit back safe in the knowledge that their simple investments will do better than most fund managers and private investors!

More guidance from lovemoney.com

Still want to learn more money stuff? Then how about:

Reading how to Stop inflation destroying your savings.

Taking up the Goal to Save for your child’s future.

Or sit back and watch a video on Property vs. pensions.