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Happy birthday, index funds

Happy birthday, index funds

13 September 2006

5:57 PM

13 September 2006

5:57 PM

What has been the single most successful and socially useful investment innovation of the last 30 years? Although paradoxically few investors will know what it is, or why they should be grateful that it exists, my nomination is the index fund. On 31 August this year, largely unheralded in the media, this dull but remarkable invention celebrated its 30th year in existence.

An index fund, also known colloquially as a tracker fund, is a fund that does nothing more exciting than set out to mimic the performance of one of the market indices that are regularly featured in media reports about the day’s events in the stock market. Most of us are attuned to hearing such names as the Dow Jones Industrial Average (the oldest Wall Street index) and the ‘Footsie’, or FTSE–100, which has been recording how London’s leading shares have moved since 1984. But what, you might well ask, is so special about a fund that prosaically tries to mimic the performance of this or that index?

The surprising answer is: a hell of a lot. The humble index fund is, if you like, the universal joint in the serious investor’s tool-kit, a greasy gizmo that allows Joe Public to gain all the benefits of investment in the stock market without the expense, risk or scandal associated with the hazardous business of being sold (or mis-sold) the wares of a professional investment firm.

What makes an index fund possible

is modern technology. Instant communications and computing power make it possible to replicate the behaviour of almost any leading stock market index from minute to minute throughout the trading day. Index funds do that prosaic job for hundreds of different markets. Ironically, when a recently fired professional investor called Jack Bogle offered his prototype index fund to retail investors in the United States 30 years ago, as the first offering from his new firm Vanguard, it was ridiculed as an eccentric idea that would never catch on. For five years nobody even bothered to copy him.

Yet today more than five million investors have a share in that one original fund alone. With more than $100 billion in it, the Vanguard S&P 500 index fund now ranks as the second largest fund of any kind in the United States. Its success has spawned thousands of imitators around the world. So powerful has the concept proved in practice that an estimated 25 per cent of the world’s entire stock of professionally managed money is now invested in index funds of one kind or another.

What makes this powerful plodder so special is that it produces spectacularly dull but spectacularly reliable results. Over any ten-year period, broad market index funds like the Vanguard 500 fund routinely return more money to investors than

75 per cent of the actively managed funds run by highly paid investment professionals. While the latter command bigger advertising budgets and bring in more fees, it is their seemingly gormless country cousins, the index funds, that produce the more reliable results for clients.

What’s more, because they cost virtually nothing to run (which is one of the secrets of their success), they do so at a fraction of the cost. Or at least they should do. But not so in Britain, alas, where with honourable exceptions the average index fund is still sold to unsuspecting punters with an outrageous annual management fee of

1 per cent per annum. This compares with the 0.12 per cent that Vanguard charges retail investors for its S&P 500 index fund, and the 0.1 per cent (or even less) that the average pension fund or insurance company, as a professional trade buyer, will pay for the same thing. The cheapest UK index funds (offered by Fidelity, Foreign & Colonial and Abbey National) have annual charges of 0.3–0.35 per cent.

High charges make a mockery of the index fund concept, which is nothing like as effective unless priced for what it is, which is a cheap-as-chips commodity. Maybe for that reason — but also because UK funds only shift if providers grease the palms of financial advisers with sales commissions — index funds have never caught on here in a big way. Despite their inherently superior risk-reward characteristics, they account for barely 6 per cent of funds owned by private investors. Even Fidelity, the UK market leader, has failed to shift many of its index funds, despite slashing annual fees to a lowest-yet 0.3 per cent.

Nothing highlights better the continuing gap between rhetoric and substance in British financial services than the failure of providers here to emulate Jack Bogle’s index fund success in the United States. Every professional in the City knows that index funds should be core building blocks in any long-term investor’s portfolio. Since 1976 the Vanguard index fund has produced a compound annual return of

12 per cent, better than three quarters of its peer group. Yet even 30 years on, ignorance and professional omerta still stand in the way of more investors enjoying the fruits of this unsung hero of the investment world.

Jonathan Davis is editor of Independent Investor.

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