This article was published on 24 October 2006. Some information may be out of date.

Why some advisers don’t recommend index funds

A while back I wrote that I still think index funds are the best way for most people to invest in shares, even though they are scheduled to lose their tax advantage next year. That has prompted an intriguing question from a reader:

“If index funds outperform all other forms of sharemarket investing over a long period of time (10 years?), then why do advisers recommend other forms? Is it simply due to their commission?”

Firstly, index funds don’t outperform everything else. Those with enough time, money and knowhow to directly buy a diversified porfolio of shares, or those who buy just a few shares and happen to be lucky, will often do better than the average share fund investor.

That’s because they don’t pay any fees, and often they don’t pay any tax on capital gains.

However, for the rest of us — short of time, money, knowhow or simply the desire to directly invest — share funds can be a good choice.

Share funds come in two flavours:

  • Index funds, which invest in all the shares in a market index.
  • Active funds, which hire people to decide which shares to buy and sell.

Such people cost money, and active funds usually trade more often than index funds, incurring brokerage and other costs. For these reasons, fees on active funds are higher. And — all else being equal — a fund with higher fees is going to give investors a lower after-fees return.

That doesn’t mean, though, that index funds always beat active funds. Far from it.

Index funds perform about the same as the sector of the share market that their index represents. In other words, they are average performers.

Before fees, then, about half of all active funds will do better than index funds in any given year. Even after fees, maybe one third will do better than index funds.

It’s important to look over the long term, though. And yes, ten years is a good minimum period for a share investment. Twenty years is even better.

Most active funds don’t stay above average year after year, or even in most years. They have their ups and downs. Over a decade or more, very few beat index funds, after fees.

So which are these “very few”? That’s the tricky bit. The managers of every active fund say they will be future outperformers.

Some will point to figures that show they outdid a market index in the past. Be wary. Often they are not comparing themselves with the appropriate index — one that covers the same market sector as their investments.

Even if they use the correct index, just because they outperformed in the past is absolutely no guarantee they will continue to do so. Fund managers are often reluctant to admit the role luck plays in their performance.

I’ve been watching for years, and I reckon there’s no way to pick a winning share fund manager in advance. That’s why I invest in index funds, which are usually close-to-top performers over the long term, rather than active funds, which could come anywhere from first to last.

And so, finally, to the point of the reader’s question: Why do advisers recommend other types of share investment?

As I said, direct share investment suits some people. Beyond that, some advisers’ active fund recommendations are undoubtedly driven by the commissions — or holidays or other perks — that they receive.

In other cases, advisers genuinely think the managers of an active fund will outperform index funds over the long term. But it would take some pretty amazing evidence to convince me that it would be more than luck.

Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.