Look Outside P2P Lending: Investing In Shares

Recently, for a friend, I returned to my old stomping grounds of share investing to look at the best options for her. I was interested to know how these had changed since I last assessed them in great detail, which would have been early in 2014.

Share investing in parallel with P2P lending is an excellent combo. (After all, it's one of the four ways that most people should save and invest – as in the name 4thWay.) So, as a Christmas treat for myself, I'd like to end the year by deviating from P2P lending to write up my latest research on investing through the stock market.

If you're investing for a long time – at least ten years but especially for 20 years or more – share investing should still be a very substantial part of your long-term investing plan. That's even if you've put a large proportion of your investing pot in P2P lending as well. (Which is a good investment for those with investing horizons starting from three to five years – and upwards for as long as you want.)

The record of investing in established companies listed on the stock market is fantastically good. Even in very long periods it's not immune to risk, but you can well contain the risk with simple strategies, much like you can with P2P lending. Like P2P lending, share investing has an excellent chance of beating inflation by a substantial margin.

What's new in share investing?

For me, the big point of interest I was curious about was whether a relatively new kind of share fund launched probably around 15 years ago has finally got the history it needs to show whether it's living up to its potential.

These funds I'm talking about are often called fundamental trackers, which are supposed to be an improvement on the original index trackers. (I'll come to those in a few minutes.)

Fundamental trackers spread your money across many of the shares listed in specific stock-market indices. These indices are typically in specified countries and they could be international. What's special about these trackers is that they weight the amount you lend in each business based on mechanical formulas. Those formulas are take into account signs that the share prices might be undervalued, or that the company might grow rapidly, or that its share price has momentum and appears that it will keep rising.

Having read some research on mechanical selection by my favourite share-investing researchers, Dimson, Marsh and Staunton from the LSE, who do the Credit Suisse Global Yearbooks and Sourcebooks, I feel these sorts of trackers have potential. By having very low costs, these should outperform the market and the vast majority of actively-managed funds. So the theory goes.

So I looked through as many studies on fundamental indices and on fundamental-tracker funds' performance as I could find, and as many articles as possible, reading goodness knows how many thousands of words.

But forget the drum roll. While these funds have been around for one or two decades, I'm sad to report that the evidence is inconclusive and a lot more research still needs to be done. We still need to see more clear, serious outperformance of these funds in the real world and be able to establish which types of fundamental trackers “work” in this way.

The research shows good reason for hope – but don't allow yourself to be persuaded just by the bits you like. The pattern of actual fund performance is far from clear. The initial evidence suggests to me that many of these trackers probably aren't using very good basic formulas for selection or that some formulas might break easily once other market participants catch on.

I also suspect that the size of these funds will often be hampering them from achieving any significant outperformance.

This all means that, even if fundamental trackers do turn out to be genuinely good ideas, as I still think they will, you won't be able to just put your money into any old one.

The bottom line for me is that I don't feel like any research is truly comprehensive and deep enough for investors to work with in any practical kind of way, yet. Still, I'll link to some of the more interesting reports at the end of this page.

Sorry if you're disappointed with that conclusion, but I think it's well worth investors staying up-to-date on these. We'll have to wait some more, and I suspect it might even be another 15 years before fundamental trackers are proven, and that we have the information and tools to select them easily. Maybe I'll write another update on that in December 2036!

Good old plain index trackers

It's not even necessary any more to look at the performance of ordinary (non-fundamental) index trackers to see how they compare to actively-managed funds.

These have now been proven for approaching 50 years to be consistently better than other share funds. However, just for you, I did glance at a good number of them to re-confirm the obvious. And, as usual, these automated, mindless funds have still been comfortably doing better than the clever-clogs' who try to select outperforming shares on your behalf.

Ordinary index trackers track stock-market indices that are weighted by the total valuation of each company in the index. These are the indices that you'll be most familiar with, like the FTSE 100, for example.

So, if all the companies in the index are collectively valued by the market at £1 trillion, and one of those companies is worth 5% of that (£50 billion), then 5% of your money invested in that fund will go into that company. A £100 investment will see you owning £5 of that business.

This form of index tracking is not perfect, because that company – or any other – could be overvalued. But it turns out that simply buying the whole market like this, while keeping fund costs as low as possible, is the best way to do better than most other investors.

The reason is that actively-managed funds have higher costs, and so those funds typically perform worse each year by roughly the size of the additional cost.

That small difference each year adds up to a very large amount over many years. And it's surprisingly consistent. There are very, very few funds that manage to beat index trackers for a decade or longer. And you can expect that outperformance to end – at the very latest, as soon as the fund manager leaves and a new one comes along.

Index trackers have been just about the best way for share investors to beat inflation and get a satisfactory return in the long run. And that still remains the case. It's good to know that some things never change.

I hope you have all have a great Christmas and a really good 2022!

Further reading

Read about the four ways to save and invest in Peer-to-Peer Lending Vs Other Investments.

Here's some of the research into fundamental indices and fundamental index-tracking funds:

Summary about fundamentally-weighted indices, and research on the theoretical rewards, from FTSE: FTSE Paper: FTSE Fundamentally Weighted Indices.

EDHEC Risk And Asset Management Research Centre: A Comparison of Fundamentally Weighted Indices: Overview and Performance Analysis.

Lund University: Investigating the performance of fundamentally-weighted portfolios.

University of Regensburg: Fundamental Indexing Around the World.

Financial Planning Association: Do Fundamental Index Funds Outperform Traditional Index Funds?