Can’t see the Wood (ford) for the Trees
To obtain long-term returns which are higher than inflation (the rate at which the price of goods and services tend to increase over time) you’ll need to invest a sizeable amount of your capital and any ongoing regular savings into a mix of real assets such as the shares of profitable trading businesses or those that hold commercial property.
Although the value of your investment will fluctuate up and down (which can sometimes be as much as 50%), over the long-term your investment should grow to reflect the fact that company profits generally rise at least in line with inflation.
To avoid the risk of a complete loss of money in the event of the failure of individual companies (e.g. Carillion) or sustained poor performance (e.g. ITV plc), it makes sense to spread your money across lots of companies that cover different sectors. If you have enough time and money you could try to do this yourself, but if not the easiest way is to invest in an investment fund that does it for you.
There are two types of investment fund: index or active.
With an index fund a computer (sometimes with oversight from a human) buys and sells companies so as to obtain a return that is as close as possible to that provided by the stockmarket as a whole, as represented by an index (e.g. FT All Share Index or S & P 500).
Index funds usually deliver a return that is slightly less than the stockmarket benchmark they are following, as a result of the charges they levy to manage your money. But these charges are usually very low, typically less than 0.25% per annum.
With an active fund a human manager decides what shares to buy and sell with the aim of producing a return that is higher than the stockmarket, as represented by whatever index they use as a benchmark.
Historically over the long term (more than 10 years) the average active fund has produced a return that is LESS than an average index fund. This is mainly because active funds charge a lot more to manage your money than index funds, typically 10 x more.
But sometimes active funds underperform index funds because the manager also makes bad investment decisions.
Neil Woodford is a multi-millionaire active fund manager who was one of the handful of people who consistently beat both index funds and his active manager rivals. After a 20-year successful career at Invesco, one of the world’s largest fund management companies, in 2014 he set up his own company, Woodford Investment Management.
Billions of pounds poured into Woodford’s new funds, including from local authorities, wealthy families and the massive financial services company St James’s Place Group. After great returns in the first year, most of Woodford’s funds then went on to underperform their relative benchmark.
One of the reasons for this underperformance was that Woodford started investing a lot of his money in smaller, untried companies that were hard to value or that paid no dividends. Eventually funds started flowing out of his funds as more and more people wanted their money back. This forced Woodford to suspend withdrawals from his largest fund - UK Equity Income - to give him time to sell off holdings in the fund.
You can read a good summary of what went wrong, by my fellow FT columnist Merryn Somerset Webb, here.
What can we learn from this episode?
The handful of investment managers who outperform their index benchmark rarely maintain that performance over the long term. Either they retire, die or, as in Woodford’s case, they eventually make big mistakes. The FT put it well in another good article about the Woodford debacle:
“Most of all, though, the Woodford affair has provided further evidence that star fund managers are a dying breed in an era when investment is increasingly managed by machines that track benchmarks.” - Neil Woodford’s woes expose a flawed investment model (FT: 7 June 2019)
My family’s long-term equity exposure is obtained via a low-cost global equity fund of index funds. Yes, it move up and down in value, sometimes a lot, but it is low cost, it gives us whatever returns markets deliver (good or bad) and we don’t have to worry about a human making bad investment calls that lead to either big underperformance of the overall stockmarket, or our money being locked in.
Sometimes as investors we can’t see the wood for the trees, and sometimes that means we often misunderstand the risks that active managers take with our money. Buying an active fund, rather than an index fund, is a bit like looking for a needle in a haystack. Forget the needle (active) and buy the haystack (index). It’s all you need to have a successful long-term investment experience.