If you are a novice investor and you don’t want the headache of picking funds to invest in, then investing in passive funds could be the answer. We explain how they work, their limitations – and what you could pay in fees
Investing in the stock market can deliver better returns than savings over the long term but, with the fortunes of some companies likely to flounder while others flourish, it is notoriously difficult to pick the winners.
Passive investing can remove these difficult decisions. With this, rather than actively picking the companies that will do well, a fund mirrors the performance of a particular stock market index such as the FTSE All Share or the S&P 500.
Although you still have the risk that your money can fall as well as rise, passive investing does offer an element of certainty.
“Your return will be the same as the index, minus the annual charge,” explains Damien Lardoux, head of impact investing at EQ Investors. “With an active fund, you could do better, but you could also do worse than the index.”
Passive funds are not limited to stock markets, with indices available for fixed-interest investments such as bonds and gilts and even commodities including gold and oil.
You also have the reassurance that you will be in good company.
“Professional institutional investors such as pension funds, banks and insurance companies have used passive investments for many years,” says James Norton, senior investment planner at Vanguard UK. “They have multi-million pounds in passive funds.”
Main ways to track an index
There are several ways a fund can track an index. The easiest way, which is known as full replication, is to buy all the shares in the index in the same proportions as they are in the index.
This keeps costs down as, other than buying the shares initially, the management group will only need to tweak the holdings when a company joins or falls out of the index or it issues additional shares.
While this full replication approach works well for a small index such as the FTSE 100, where there are hundreds or even thousands of different constituents in the index, it is common for a management group to take a slightly different approach.
“The manager might make a close approximation to reduce the number of holdings, often by omitting the very smallest shares in the index,” explains Justin Modray, director of Candid Financial Advice. “These minnows have negligible impact on the overall performance of the index.”
Where this sampling approach is used, managers will keep an eye on the holdings to ensure they continue to deliver performance in line with the index. Additionally, as the fund grows, it may be possible to switch to full replication.
Synthetic replication is another option, with the management group achieving the performance of an index by using derivatives called 'swap contracts'. These promise to pay index returns to the fund but, as they are arranged through counterparties such as investment banks, there is extra risk. If the counterparty does not deliver or goes bust, the fund could lose money.
Although he prefers physical replication, Lardoux says there is a place for this synthetic approach.
“Some indices are difficult to replicate,” he says. “This is the case where the assets are illiquid, or with commodities such as gold.
Investing in funds with environmental or social emphasis
Some passive investments allow you to put money in companies that reflect your views.
Demand for ESG — environmental, social and corporate governance — passive investments has taken off over the past five years or so according to EQ Investors’ Damien Lardoux.
“Some funds will use exclusions, removing companies involved in industries such as tobacco and munitions, while others will invest across an index, increasing their weightings in those that have a positive ESG rating,” he explains. “You do need to understand the nature of the fund and whether it matches your ESG views.”
Passive funds can also fall short with investors really committed to ESG.
Lardoux explains: “One of the biggest impacts of ESG investing is through engagement. Active managers engage with the companies they invest in and can really influence their activities. This is less likely to happen with a passive ESG fund.”
However, he has a simple ‘sniff test’ for anyone hoping to combine passive investing with their ESG beliefs.
“Look at the top 10 holdings in the fund,” he says. “If they are the sort of company you would like to invest in, then it is a good indication that it is suitable.”
Price of being passive
Cost is where passive investing really stands out. Without the need for a fund manager and a team of analysts, charges can be pared right down.
“Index tracking can be done using computer programs,” says Nicholas Hutton, head of UK iShares & wealth sales at BlackRock. “As they don’t need to undertake extensive research, passive funds are cheaper to purchase than active ones.”
For example, according to figures from Morningstar, while the average annual charge on an active UK large companies fund is 1.02%, the average for passive funds is 0.26%. On global funds, the average passive charge is 0.29%, with active funds charging an average of 1.27%.
Although the difference between the average charges may not sound like much, it can make a huge difference over time. For example, according to Candid Money’s fund charges impact calculator, and assuming an annual return of 4%, paying £100 a month into an active fund with a charge of 1.02% would give you £13,964 after 10 years, with £753 taken in charges. Plump for the passive fund at 0.26%, and you would be £558 better off, with just £196 paid in fees.
Having these larger charges also makes it harder for active managers to beat the index.
“If an active fund has a charge of 1%, the manager has to beat the index by 1% to break even,” says Norton. “Doing this year in, year out isn’t easy and, although it varies from market to market, around 70% of managers fail to beat the index.”
Even though passive funds offer lower charges than their active peers, it is sensible to shop around as there is plenty of variation.
“Competition puts downward pressure on charges, so if you get a popular index such as the FTSE 100 or FTSE All Share, you can find funds that charge as little as six or seven basis points,” explains Dimitar Boyadzhiev, senior analyst, passive strategies at Morningstar. As an example, Vanguard’s UK All Share fund has an ongoing charge of 0.06%.
Passive funds’ limitations
Although they have cost and the certainty of index performance on their side, passive funds do have some limitations.
“They are not practical for every type of asset,” says Modray. “Active management is the only option for assets such as physical commercial property and absolute return.”
Be aware that, although these funds give you exposure to everything – or just about everything – in the index, it might not be as evenly spread as you imagine.
“Most trackers are weighted according to the market cap [size] of each company, so more of your money will be in the larger companies,” explains Ryan Gardner, investment director at Quilter Investors.
As an example, he points to the FTSE 100.
“At the end of April 2020, the top five companies made up 27% of the index and the top 10, 44%. That’s almost half of the performance from 10 of the 100 companies,” he adds. “It is possible to have an equally weighted passive fund but, as there are more transactions to maintain this equilibrium, they can be more expensive.”
The other issue with passive funds is that they are never going to beat their index.
“Any rises are limited to the overall index increase,” says Sarah Coles, personal finance analyst at Hargreaves Lansdown. “In the good times, active managers will aim to choose companies that outperform their peers, and in more difficult times, while a tracker fund will fall with the market, an active manager could choose companies best placed to ride out the turbulence.”
Pairing active and passive funds
Building a portfolio that includes passive and active funds can give you the best of both investment styles. Our experts recommend the following pairs:
Justin Modray, director of Candid Financial Advice:
Passive – Vanguard FTSE Developed World ex UK
Active – Fundsmith Equity
“The Vanguard fund provides wide global exposure, while Fundsmith invests very differently to the index, complementing it nicely.”
Teodor Dilov, fund analyst at interactive investor:
Passive – iShares Global Clean Energy
Active – M&G Global Macro Bond
“When combining strategies, it is important to increase diversification to reduce risk. That includes factors such as style of investing, market cap, sector exposure, geography and asset class.”
Sarah Coles, personal finance analyst at Hargreaves Lansdown:
Passive – Legal & General International Index TrustActive – Rathbones Global Opportunities
“The Legal & General fund is a global tracker, with the Rathbones fund offering a different approach by aiming to invest in the small number of companies it expects to become global leaders.”
Building a passive portfolio
If these limitations are not an issue, you can take advantage of their lower charges and build your investment portfolio entirely from passive funds.
Start by thinking about your attitude to risk and your investment aims to determine the mix of assets you hold.
As a general rule of thumb, as you move up the risk spectrum you should reduce fixed-interest holdings, such as bonds, and introduce more equities, starting with the UK and global and moving into areas such as Asia and even emerging markets.
“Someone looking for medium risk could choose a corporate bond tracker, a UK equities index tracker and a global equities tracker,” explains Coles. “A little more conservative and they could include a gilt index tracker too.”
You can also simplify things with just one passive fund. For example, Vanguard’s LifeStrategy funds are a series of trackers investing in equities and bonds. They range from 100% equities for those happy with risk through to 20% equities and 80% bonds for the more cautious.
Getting more active
When it comes to building a portfolio, it does not have to be either passive or active. Many investors like to use passive funds for their core portfolio with additional active funds to bring a touch of specialism, invest in areas that are not easily accessible for trackers or to give the potential for outperformance.
Modray suggests going active for gaps, such as property, in a passive portfolio but also where a manager invests in a different way to an index – for instance, focusing on small companies or looking for those with the potential to be the next big name.
“If you pick a manager that invests differently, it can act as a hedge to your passive investments, potentially delivering a return when stock markets fall,” he explains.
Norton agrees that a mix of active and passive can work well but he says you need to understand the risk when adding the human touch.
“Be prepared for underperformance when their style is out of line with the market. For example, a manager with a value bias will underperform a growth market,” he says. “You also need to be able to access them at a low cost as this makes such a difference to the performance.”
Teodor Dilov, fund analyst at interactive investor (Moneywise’s parent company) adds: “Most investors use passive instruments where they replicate the index of an efficient market – one with an established financial infrastructure where all information is easy to access, and potentially already reflected into the price of a security, and reporting standards are more rigorous.
“On the other hand, a more specialist solution, which requires either good knowledge of the local market and company specifics, or additional technical knowledge, might be better used in an active vehicle.”
Time for review
Passive investing does not mean you can get away with doing nothing. Coles says it is important to go back to the portfolio regularly, sell a little of what has done well and reinvest elsewhere.
“Given the cyclical nature of markets, there is always the risk that assets that have outperformed most recently could fall out of favour,” she says.
Even if you have only plumped for one passive fund, check regularly to make sure that it is not well off the mark in its tracking and that it remains competitive on charges.
Also review your investments if your circumstances change. Getting married, divorced or changing your job could alter your investment objectives as well as your risk profile.
While a regular check is prudent, Norton says it does not have to be particularly frequent.
“You might want to rebalance your portfolio if the weightings shift by more than 10%, for example,” he explains. “If it is easier, you could set a diary date, looking at your funds every quarter, six months or even annually.”