Investment success, the easy way

Arguments over “index tracking” funds can cause punch-ups among normally staid investment advisers, but it all depends what you want from life.

What if we said we had found a stock that could almost guarantee you better-than-average performance? Would you think we had lost our marbles? Would you be ever so slightly interested all the same? Well, you should be interested, because it’s true.

As ever, there are a few catches. First, you’d have to give up all hope of doing more than a 1–2% a year better than average. Second, you’d have to put 25% of your money into banks and almost 11% of your money into BHP Billiton alone. After the performance of these stocks over the past few years, you might be justified in thinking this entails a lot of risk.

The stock is the streetTRACKS S&P/ASX 200 Fund, (ASX code STW), which is an exchange traded fund (ETF) managed by State Street Global Advisors with the aim of tracking the S&P/ASX 200 Index.

ETFs are a cross between managed funds and listed investment companies (LICs), with the idea being that they give you the best of both worlds. To you and me they look “closed-ended”, like an LIC, and their securities are traded via a broker, so they avoid the costs of fiddling around with units for retail punters. As a result, the streetTracks 200 Fund has annual costs of just 0.29%. But to institutions, ETFs appear “open-ended”. So, if the security price moves away from the underlying net asset value (NAV), then a big bank or broker will come along and swap cash for new units or vice versa. This only involves a few transactions, so it’s not too expensive, but it keeps the security price close to the NAV.

So that’s the ETF part of the equation. What about index tracking? Well some people will tell you that it’s a one-way road to investing nirvana, while others call it the investment equivalent of cavorting with the devil. The truth is far more mundane.

A stockmarket index is a basket of shares designed to reflect the overall performance of a market or sector. So the S&P/ASX 200 Index (broadly speaking) contains the 200 biggest stocks on the ASX, in proportion to their market capitalisations. An ETF that aims to track the S&P/ASX 200 Index will buy only these stocks, in the appropriate weightings, so that its portfolio '” and distributions and total returns '” mimic the underlying index.

So is that a good thing? It depends how you look at it. One advantage is that you can be sure to have a performance that’s very close to the stockmarket average. This is also the main disadvantage. You see, index trackers simply do just that: track the index. Whether that’s good or bad depends on what you want from life.

Many people will be happy to know that they’ll get the average investment performance of the market, particularly if they know they can do this very cheaply and tax-effectively, thereby actually putting themselves slightly above the average investor (ETF index trackers need to do very little trading, so capital gains tax liabilities should be small, at least until you come to sell the actual securities). And tracker investors should find themselves in a higher percentile of investors as time goes on, as the extra costs of other strategies weigh increasingly heavily.

Extremely low costs

Because of its extremely low costs, even relative to other index tracking funds, if you want to track the Australian stockmarket average, then we think the streetTRACKS 200 Fund would be a very good way of doing it.

But you only live once, as they say, and many of us are wired to try to do better than average, in which case an index tracker clearly won’t suit. As we’ve said, most people that try to beat index trackers will fail, but that isn’t necessarily a reason not to have a go. And it’s fair to say that the most successful investors over the past 100 years or so have followed a form of the value investing philosophy.

It’s also true that index trackers don’t have a monopoly on low costs and taxes. By buying undervalued high-quality stocks for the long term, you can aim for top performance while also keeping costs and taxes low. You can see this approach in action through our recommendations, which typically show a large proportion of Holds.

A further difficulty with index trackers is that they don’t offer you the opportunity to create a portfolio to suit your personal needs. After all, you can build your own portfolio to cater to your own requirements for things such as income and risk. With a little care, you can also design a portfolio so that different bits respond to different economic stimuli. But with an index tracker, there is no such opportunity: you get the index portfolio, and that’s that.

So, while an index tracking strategy will almost certainly outperform the average investor, average investors don’t necessarily apply sound value investing principles; neither do they necessarily keep costs and taxes down. If you do these things, we think you can do better than the average investor '” and better than index trackers too.

This article, written by James Carlisle, first appeared in The Intelligent Investor newsletter, http://www.intelligentinvestor.com.au