Chapter Four: Are index funds riskier than managed funds? Part II

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Part II: What is a risk and why market fluctuations are not the pension savers’ enemy?

In Part I of the Chapter, we discussed real-life scenarios which show that, in one way or another, investment is risky, as is life. Even the most brilliant analyst can only hope that his predictions will come true. This is something we have to accept. Fear of risks may prove as damaging to an investor as recklessness:

If the Estonian pension funds continue to operate with the same cautiousness as in previous years while taking huge bites out of pension savers’ savings in commission fees, we have a problem.

We discovered that Swedish pension funds are investing ever more boldly, charging less and less in commission fees from customers. Sweden’s largest pension fund is an index fund. Should our assets in Estonian pension funds continue to grow at an annual 3% and those of Swedes at an annual 6-7%, in 30 years, they will have generated twice the amount, while making the same payments.

Sweden also benefits from a more efficient disbursement system: each euro saved grants the pensioner 30% higher lifetime pension than our banks and insurance companies currently provide. Overall, Swedes will get a pension three times higher, while contributing an equal amount of money!

Indeed, this is quite dismal: if we continue on the current path, the future Estonian pensioner can only dream about a summer cottage in Muhu Island or a spa package in Haapsalu. Wealthier neighbours will simply outpay us.

What is risk?

Essentially, risk is a sinister, ill-tempered figure lurking in the shadows. In financial theory, risk is simply the possibility that your return on investment will prove different from the initial forecast. In a high-risk investment, the actual return may prove a lot lower, but also a lot higher.

In the present-day world, investors without any risk appetite must face the fact that their assets will show zero growth.

For example, the sovereign bonds of Germany can be considered an almost risk-free investment. Depositing money in an Estonian bank also involves quite a low risk. The return on such investment is 0%. Inflation and administrative fees are inevitable. Upon retirement, you will thus have even less money than you contributed.

This partially explains the poor yield of our pension funds: if you keep 40% of the fund assets in a bank account or in German bonds, you will lose 40% of the expected yield.

Tõnu, stop beating about the bush! Are index funds riskier than managed funds?

Indeed, I was carried away by my own thoughts. Short answer: no, they are not. In an index fund, your assets are exposed to market risk. In a managed fund, the fund manager replaces a part of the market risk with human risk.

In an index fund, your money will earn exactly as much as the global market is growing on an average. If the global market drops, you will lose as much as the market loses on an average.

In a managed fund, the fund manager tries to beat the market average. Usually, without any success: global statistics suggest that managed funds usually perform worse than automated funds. As discussed in Chapter One, it is extremely difficult to find a fund manager able to outsmart the market. It is even more difficult to employ such a fund manager in our service.

If your fund manager is truly among those few who are able to pinpoint the shares which will grow beyond market average, and to buy low and sell high, your investment is bound to generate a yield higher than the market average. However, if your fund manager’s attempts to time the market and identify undervalued shares fall flat, your investment will generate a yield lower than the market average.

The risk level of managed funds may change over time, e.g. upon change of fund manager. As always, there are no free lunches. When the risk level changes, the expected yield will change as well.

During the global crisis of 2008, no Estonian fund manager was able to protect investors against market decline – the value of all pension fund units plummeted, at least as much as the market index, or more.

Nonetheless, Estonian fund managers continue to promote the self-confident myth that a managed fund is able to “pull the plug on time”. And that an investor who has opted for an index fund should time the market himself, hopping between funds. One can only guess the fund managers’ true motive for doing so. In all likelihood, their knowledge of index funds is superficial. They are also likely to lure people into high-commission funds that are much more profitable for the management company.

In any case, it is bad and dangerous advice. Why?

In an index fund, your assets are exposed mainly to market risk – individual human errors are of no concern. But only if you remain patient, do not panic when the market turns down and do not get greedy when the market turns up.

Passive, index-governed investment strategy means that you opt for an index fund with suitable investment rules, and allow the market to do its work. You will not intervene – rather, you will spend your time on work, hobbies and family.

Overwhelming emotions and the temptation to “time the market” are the greatest enemy of a passive investor. If you give in, you will lose the greatest advantage provided by an index fund: you will voluntarily introduce the risk of human error.

Should I really accept destruction of my assets during a crash?

Yes and no. Pension funds have a natural advantage that protects you from market storms without the obligation to do anything yourself.

Namely, the second-pillar system will disperse your purchases over a long period of time. Investments are made in the pension fund gradually: every month, you buy fund units for a certain amount of money, at current market value. Consequently, you will always get more units when their price is low, and less units when their price is high.

Let us say you are earning the average Estonian salary. A monthly EUR 72 is transferred to your pension fund. If the fund unit costs EUR 2 this month, you will get 36 units for your payment. Let us now assume that the global markets will crash next month and your pension fund unit will only cost EUR 1. For the next EUR 72 contribution, you will now receive 72 units.

In other words, when the markets are doing well and your second-pillar pension account is excelling, new units will cost good money. But when the market is suffering from a crisis and the value of your pension fund units drops, you will get new units much cheaper in return.

Pension savers’ insurance policy: dollar-cost averaging

Such a dispersement of purchase over time serves as an insurance policy accompanying your investment. Your portfolio will balance itself out, with the average price for which you purchase fund units serving your interests. The market rises and falls but you need not worry yourself about it.

This type of investment strategy is referred to as dollar-cost averaging. It is considered the most efficient and safe tool which hedges investment risks without quashing the yield.

At the beginning of the chapter, I disclosed my plans of keeping my pension assets in an index fund during a decline. Why?

Because I have discovered two things:

1. Market fluctuations are an inevitable part of investing. Over my lifetime, my pension savings will suffer from several serious downturns. Since I will be saving up for a pension for a long period of time, I am not worried about short-term, one or two-year lows.

2. Since I am buying pension fund units on a regular basis and for a fixed amount, my investments will be well dispersed over a long period of time. Throughout the history of the securities markets, patient adherence to such a strategy has made it nearly impossible to lose money.

Index funds are neither less nor more risky than managed funds. Index funds are no magic wand that will ensure a happy life and eternal youth. The experience of the global markets and a range of serious studies shows that, for most investors, a passive, index-governed strategy will help to ensure the best long-term yield. If anyone has information to the contrary, please let me know. We will continue our discussion.

It only takes a few minutes to transfer your pension to Tuleva. You do not have to be a member of Tuleva to transfer your pension, and changing funds doesn’t cost anything, you will be saving money on management fees instead! We have prepared a guide to help you out here: