The question of whether to invest in low cost index funds or more actively managed funds is a long standing one. Proponents of low cost index funds such as John Bogle have provided evidence to show that in the majority of cases, low cost index funds do trump their more active counterparts. And I am not one to argue against all this evidence. So why am I investing in actively managed funds? Simple, not all actively managed funds are beaten by low cost index funds. A very select number of actively managed funds have outperformed an index over a considerable period of time.
As with anything in the world of investing, research is key. If you look hard enough, you can find fund managers who have the Midas touch. Managers that have consistently outperformed a benchmark thorough their career and made their investors very rich in the process.
The structure of the fund you invest in is also very important. You see, just because a manager outperforms an index year in year out does not mean you will get rich, sometimes the performance fees are so high that they will eat into any returns you make. That is why you need to look at the fund structure (performance fees) and the reputation of the manager in order to decide which fund to buy into.
They were three funds that matched my criteria when it came to investing, Fundsmith, Woodford and Japan.
Fundsmith Equity Fund – Terry Smith
When I first decided that I needed to start investing, I read every book I could find, every investing report that I could get my hands on and every online article that I could possibly read without straining my eyes. During this time, I studied successful investors and looked at their investment approach and the composition of their portfolios over time. The great investors like Warren Buffet always positioned their portfolios to include wonderful companies with fantastic economic moats; companies that had a competitive advantage.
Doing further research into this investment style, I knew it was the right approach for me. The problem was that the majority of mangers who were truly great in picking wonderful companies at the right price and making their investors rich in the process were all found in the US.
So I set myself the task to find the ‘UK Warren Buffet’. Thank god for Google. It made this process far is easier than it should be. After looking through a number of articles and dismissing a number of wannabe Warren Buffet, I finally stumbled upon Terry Smith, the straight talking no nonsense value investing champion. I read one of his articles and I was hooked, I got my hands on as many of his articles as I could find.
The more I read about Terry and his investing philosophy, the more I admired this man. He wants to own wonderful companies at attractive prices and hold them for the long-term. Like Buffet, his favourite holding period is forever.
In essence, his Fundsmith fund seeks to acquire shares in companies that can do most of the following:
- generate a high return on capital employed where the return is measured by the free cash (ie, net cash profits) produced;
- find enough profitable opportunities to invest much of the cash left over;
- still have enough free cash to pay consistent dividends;
- offer the resilience that comes from having a business franchise that’s difficult to replicate, which usually means it stems from intangible assets and that much of its revenue comes from small, repeat, but necessary purchases.
Terry’s aim is to keep his investment style simple and by doing this has produced fantastic returns for his investors. The fund has produced a compound growth rate of 17.2% a year since inception. A fantastic track record.
Apart from his track record, I like Terry Smith because he does not follow the crowd, instead he is staunch with his own views. When every other manager (including Warren Buffet) have been buying stakes in Tesco over the past few years just before the crash, Terry Smith avoided it completely in his fund as he noticed that the firm’s return on capital was dropping steadily as the group expanded. That’s the sort of thing I want to pay a fund manager for, not by taking the easy route and following the crowd!
And with that, I put £1000 of my own Money in Fundsmith during the early December dip of 2014. I bought into the fund directly from the Fundsmith Website. The process is easy and can all be done online.
CF Woodford Equity Income – Neil Woodford
To many living in the UK, Neil Woodford is a household name. During his time running the Invesco Perpetual fund he produced annual returns in excess of 13% over a period of 25 years ears. What a record! In my opinion, once you risk adjust different funds, I don’t think any manager in the UK comes close to Mr Woodfords record.
The Woodford Equity fund is a fund I’m convinced will beat its benchmark year in year out. Mr Woodford traditionally invests in defensive industries. Two of the biggest industries he invests in are Health stocks and Tobacco stocks. The irony right! But this combination seems to work. He has a great record as seen above.
I have already talked about why tobacco companies are wonderful businesses. They may be immoral, but so are Alcohol Companies, Oil Companies, Fast Food Chains, Companies that offer 0 hour contracts and offer slave wages in other parts of the world where their manufacturing is based, Defence companies, Banks and basically every other company that is on the FTSE 100. So your job as investor is to find the best place to invest your money that will offer you the highest rate of return whilst still keeping your conscious clean. For example,I will never invest in an alcohol company as I believe alcohol does way more damage to society than tobacco.
Anyway, back to Mr Woodford.
The majority of the companies Woodford invests in are in the UK and with the UK market currently being one of the better valued markets in the world, I believe this fund will produced outsized returns in the years to come.
I invested £500 into this fund using the Hargreaves Lansdown platform. If you want to buy funds, I would recommend using Hargreaves Lansdown because they do not charge a fee to deal in funds, so even if you have small amounts of money, you don’t have to worry about the dealing fees eating too much into your returns.
Jupiter Japan Income – Simon Sumerville
I bought into the Jupiter Japan fund mainly for its strategy. The manager of the fund, Simon Summerville knows the Japanese markets well and over the course of his 16 year career, he has comfortably beaten the benchmark index.
The Jupiter Japan Income Fund revolves around large and medium cap stocks of companies that generate high and increasing levels of cash-flow. This is what caught my eye and this strategy will be extra beneficial considering the Quantitative Easing package the Bank of Japan is currently unleashing. Although Quantitative Easing will lift all stocks in Japan, there are some sectors which will outperform others and the manager will be aiming to capitalize on this. That is why I have gone for an active fund as opposed to an index fund which encompasses all sectors in this case.
In picking stocks, the manager uses various techniques to screen potential acquisitions such as a companies cash-flow generating ability, earnings revision and price momentum. The manger also uses technical analysis to time investment decisions. Despite the word ‘Income’ in the name of the fund, yield is not specifically a target factor of the fund but the investment style of the manager is likely to produce some yield.
I once again invested in these fund using Hargreaves Lansdown. With this fund, I invested £120 in January. Many people might look at this paltry sum and think what’s the point of investing £120, many people seem to think you need a whole Napolean-like army to start investing. They suffer from the “not enough” mentality; namely that if they aren’t making £1,000 or £5,000 investments at a time, they will never become rich. What these people don’t realise is that entire armies are built one soldier at a time; so too is their financial arsenal. So even if you have £250, my opinion would be to start investing and to add to that investment over time.
Use a Taxable Account for Accumulating funds
All the above investments were bought outside my ISA, an in a normal taxable brokerage account. This is because I bought accumulation units in the funds rather than income. This means that the fund manager automatically re-invests any dividends I get back into the fund. The long term effect of this is that the majority of my return will come from the price appreciation of the fund rather than the income that is paid out. It makes perfect sense in situations like these not to ‘waste’ your ISA. Instead I am using the other generous tax perks the UK offers, namely Capital Gains Tax Allowance and dividends allowance.
With the Capital Gains tax allowance, you can sell assets and make gains of up to £11,100 a year without paying a single penny in tax. The dividend allowance was brought in this year and takes effect from April 2016. With this, you can receive dividends of up to £5000 a year tax free! With incentives like this, the government is really trying to make people invest so make sure you take advantage of all your tax shelters.
Index Fund Vs Active Fund Performance
By buying onto these three active funds, I can for myself decide if low cost index investing is better than active management. As time goes by, I will compare my investment in index funds via Nutmeg and the investments in these active funds to see which has earned me more money. I will look at the percentage increases in each as the amounts invested are different.
So far in the time I have been invested in the above 3 active Funds which is a period of just over 11 month, they have all produced fantastic returns which justify my decision to invest in them. They have so far all produced a return in excess of 17% during my holding period and have comfortably beaten their respective benchmarks. This shows that with the right managers and fund structure in place, active funds can trump low cost index funds.
After this experience of investing in actively managed funds, I will start to buy individual stocks as per my goals. I do believe that individual like you and I can beat many of the the professionals. This is because you and I have different goals in mind, we are after long-term success and don’t care about the performance of our portfolios on a yearly basis. Many professionals out there tend to focus on the short term in order to attract new investing customers. Many funds work too trying to look good in the short term, but this can have a detriment to long term performance.
More details of the above funds can be found in the analysis I did of them in January of this year.