Secrets Of Success: Why funds remain a firm favourite

It is fair to say that I have written more about funds, in the past 12 years that I have occupied this space, than I have done about almost any subject. It is also probably the subject on which I have repeated myself most often. The only justification I can find for this is that all the evidence I see suggests that funds are how the great majority of readers, understandably, choose to put their money to work; and the area where the same mistakes, equally understandably, are repeated most often.

The irony is that collective investment schemes, as funds are more properly known, are in my view one of the great financial innovations of the late 19th/early 20th century. In theory, they offer investors a simple, convenient and tax-efficient way in which to hold diversified portfolios of shares, bonds and other types of investment, something that most of us have neither the time, the willingness, nor the expertise to do cost-effectively ourselves.

Other things being equal, that has to be a positive net gain for the nation. You only have to look at the rise of the supermarkets over the past 40 years to appreciate how highly people have come to value convenience and choice when it comes to food shopping. How far upmarket you choose to go as a food shopper is a function of how high a price you are prepared to pay for that choice and convenience.

The difference between food and funds, however, is that the linkage between price and value for money, on which even a Tesco or a Waitrose ultimately still rely, appears to break down so often. If you have a Tesco on your doostep, but no cheaper alternative, the cost and hassle of having to go get yourself to the other location can easily offset the potential benefit of changing your destination.

With funds, however, there is often today a cheaper (and quite likely a better) alternative that the investor can buy without any loss of convenience. Yet few investors show any willingness to take advantage of that fact. The genius of the fund industry, you could argue, has been to turn what in reality is often a commodity product into a branded offering that commands a premium price when, usually, none is either deserved or earned.

What is even more remarkable is that the bill for building these frequently bogus brands is paid for by the self same investors who are being short-changed as a result. Not only do you not get what you pay for in many funds, you actually pay extra for what you don't get. This modern day version of a three-card trick happily supports the lifestyles of many of my best friends in the business.

There seems to me no doubt that the funds business is characterised by market failure of some sort. I attribute this primarily to a combination of investor ignorance and the distorting effects of the intermediary/commission system which is at the heart of the fund distribution system in the UK. While the Financial Services Authority is yet again trying to reform the commission system, it is evident that the dominance of powerful intermediaries is in part the result of the way the FSA chooses to interpret its regulatory and investor protection remit.

To put it bluntly, the reason why even a well-informed investor cannot buy most of the funds they would like to buy without paying an intermediary is that regulators have a vested interest in keeping a middleman in place. When scandals occur, it is much easier to come after a commission-earning adviser, than it is to try and provide recompense directly to investors who make mistaken fund choices.

Even well-informed investors have difficult choices to make when it comes to choosing funds. Unfortunately there is little evidence that financial advisers are particularly good at the job. One reason is that investors' expectations are often so unreasonable; everyone wants high returns and low volatility, a combination which by its nature is mostly unattainable.

My conclusion about funds is still that if you know what you are trying to do, and know how to pick the best funds for any investment mandate, choosing half a dozen funds run by long-serving managers will produce everything you could want from an investment programme – long run returns that can beat the market.

If you can sustain a programme of this sort for long enough, and hold your nerve through market wobbles, the amount of money you end up with will be more than enough for any reasonable person's needs. There will always be someone who has done better than you, but the wise target in investment is always the best return possible, not the best possible return.

Once you have found the few exceptional managers around (an Anthony Bolton, a Philip Gibbs or Neil Woodford), the time to sell their funds is "almost never". It is usually far better to adjust the balance of your portfolio at the margin than make wholesale changes. If you can catch the big moves in investment style that I mentioned last week, by adding managers who have an appropriate style at the right moment, the better still your results will be.

For everyone else, passive investing – using index funds and now exchange-traded funds as well – is unquestionably the best way to go. Twelve years of banging on about the importance of low cost in index funds has, I regret to say, made only limited headway in bringing down the cost of retail index fund here to the minimal levels you can find in the United States.

An expensive index fund is a contradiction in terms, and those fund groups that still charge you 1 per cent per annum as a management charge, when 0.3 per cent is now available, should be ashamed of themselves. One day, I keep promising myself, I must find a way to offer readers a Vanguard-style range of funds that UK investors can buy safely without having to worry about the currency risk, but that remains a challenge for another time. If I do ever find a way, my website will have the details.