The Little book of commonsense investing

Actively Managed Funds & Costs Involved

Many investors choose to invest their money in actively managed funds. These funds are expensive because of fund management and brokerage charges. While these costs look insignificant percentage wise, eventually they eat away a substantial part of your profits.

For instance, if you had invested $10,000 in 1980, by 2005 you would have 70% less if you invested in an active fund rather than an index fund, because of these charges.

These costs are bearable if the fund performs well. But are these high returns sustainable over a long period?

Also, buying on low and selling on high is never a sustainable strategy. It might work in the short term, but it is far from sustainable in the long run. The strategy cannot produce more returns than what the companies are earning.

For example, if the stock price of a company is consistently rising without no substantial correlation to its earning, the stock price will take a beating in the long run. Now, if you add high costs to these funds, it may generate significantly low returns compared to low-cost index funds.

Actively managed funds are expensive and often underperform the market.

Investing directly in the stock market can be risky. Many investors do not have the expertise or patience to understand the fundamentals of the company they are investing in.

Hence, they invest in actively managed mutual funds. Now, this investment strategy can be risky because the costs of investing in actively managed funds are high.

Only a few funds perform well and there is no guarantee that these funds will do so in the future as well. The fund manager may retire or the market may underperform. Lack of innovation is another threat that wipes out successful businesses.

Only 25 of 355 funds that existed in 1970 performed better than the market and remained in business.

Most people invest in actively managed funds without knowing the implications and costs involved.

Investors are often deceived by the extraordinary returns highlighted in advertisements. They forgot to analyse the fund management and brokerage costs associated with these so-called superior returns. There’s also a lingering fear that the fund will deliver again in the future.

Where to invest –

Invest most of your money in safe, low-cost index funds

Compared to actively managed funds, index funds are more cost-efficient and diversified across sectors.

With an index fund, you invest not only in one sector but a variety of sectors and the best stocks in the economy. These funds are also known as passive funds. These funds essentially buy and hold the index, saving you buying and selling costs, fund management expenses, brokerage charges.

These savings are reinvested, which earns extra returns owing to these cost savings. If you are still not convinced, please remember that index funds usually outperform actively managed funds in the long term.

Which index fund to choose

If it comes to choosing between two index funds, pick the one with the least expense ratio. In the long term, a slight difference in the expense ratio adds up to a substantial amount.

Example: A .5 basis point difference over 10 years can mean a difference of over 6% in your portfolio.

Investing trends

Be careful regarding the investing trends and new category of index funds. You need to be careful of the latest trends in the world of investing and should not get swayed away by the short-term attractiveness of a specific sector.

For example, there are over 30 index funds in India, many of them favouring a particular sector or theme. The Nifty Small Cap 50 or Nifty Midcap 150 are two examples.

The author suggests it is impossible to predict whether the portfolio is undervalued or overvalued. Hence, an index fund such as a NIFTY 50 Equal Weight or NIFTY 50 Index would be a better option.