A very simple investment tip that you should never forget

This article is taken from our FREE daily investment email Money Morning.

Every day, MoneyWeek's executive editor John Stepek and guest contributors explain how current economic and political developments are affecting the markets and your wealth, and give you pointers on how you can profit.

Sign up free here.

Over in the US, low-cost funds are winning the battle for the hearts and minds of investors.

Last year, notes the Financial Times, funds with the lowest fees attracted “by far” the most investor cash.

In fact, the only active funds with net inflows were those that charged below 0.56% in fees. The vast majority of active funds saw money leave their funds. Meanwhile, index tracking funds continued to attract plenty of money.

As a result, nearly half of all US stockmarket funds cut their fees last year.

It seems the message is getting through. Let’s hope it continues to spread to Europe.

Guess what? Most active funds fail to beat their benchmark after costs

Competition from market-tracking funds (which just aim to deliver, in effect, the “benchmark” return, or the return of the market) is really starting to hurt active funds (which try to beat an underlying benchmark, typically the market or a sector of the market).

And little wonder – because active funds aren’t great at their jobs.

According to Italian consultancy Prometeia, more than 80% of the funds bought by private investors in Europe over the past three years failed to beat their benchmark after fees were deducted (which is what matters after all, because that’s the return that you, the investor, end up with).

As the FT reports, the group looked at 2,500 funds (including both equity and bond funds), and found that only 18% of them managed to beat the index they were measuring themselves against.

What’s also interesting (in passing) is that – on the bond fund front – it’s essentially impossible for many of these funds to beat their benchmark. Because they are designed to be conservatively run, they can’t take enough risk to have any chance of beating the market after costs.

That’s not very good. It’s not surprising though, because it’s in line with what most of this research finds.

The lesson for investors is simple: if you’ve decided on a market that you want to invest in, then unless you are convinced that you’ve found an active fund that can beat the market consistently (which is hard), then you are better going for a cheap market tracker.

The active fightback is a hollow one so far

I’ve noticed that there is a bit of a fightback in the active business right now. There are a lot of stories flying around that try to prove that either it’s time for active management to come into its own, or that charges don’t matter, or that passive investing is going to cause a massive crash in the markets, or that it’ll damage the structure of the markets somehow.

Some of this could be true. We won’t know exactly how the rise of exchange-traded funds (ETFs) in particular – which are generally market-tracking vehicles – could cause odd side-effects or higher volatility when the next market crash comes.

And markets are expensive right now, no doubt about it. When the next crash comes, anyone sitting in a tracker fund is going to be fully exposed to the slide in prices, and no doubt a lot of them will panic and act surprised, as though they didn’t know that share prices could go down as well as up.

Thing is, the same will go for anyone in actively-managed funds. The tendency of investors to jump from one “hot” active fund to another is well-established as a source of wealth-destroying behaviour.

In short, it’s hard to make the case for active versus market trackers based on the notion that active will somehow do any better during a bust. There really is no obvious advantage there.

So here’s a simple thing to remember when you’re reading all this propaganda (and it is propaganda): costs matter.

Once you’ve chosen the market, sector, or company that you want to invest in, costs are the only thing you can control. So you should focus on keeping those costs as low as possible, within reason.

Sure, now that ETFs and trackers are competing over literally 0.01% of fee differences, I wouldn’t get overly worried about the difference between paying 0.05% and 0.04%. But there’s a big, big difference between paying 1.2% and 0.2%, for example.

If you’re paying that sort of premium, then you want premium performance. The problem with that is that, if a mere one in five active funds can beat the market, then your odds of picking one of the few that do manage it are not very good.

Don’t get me wrong. I believe that there are ways to pick good active funds (we’ve discussed this a lot here – here’s a recent piece from my colleague Merryn Somerset Webb– and we’ll discuss it again soon). We also run a model investment trust portfolio in the magazine regularly (subscribe now if you don’t already) – so we do believe that there’s scope for active management to achieve better returns for long-term investors.

I also believe that active funds will be steadily forced by passive pressure to differentiate themselves far more clearly in the future. Hopefully competition from passive funds will improve the quality of their active rivals.

However, if you’re not prepared to do your homework and to take the very real risk that even a carefully-chosen active fund might struggle to beat the market (certainly in the short term), then the truth is that you should focus on cost.

It really is that simple.