When to invest in passive vehicles

The rising popularity of tracker funds partly reflects their flexibility, says Annabel Palmer

INVESTORS are increasingly turning to passive funds. In the four years to June 2013, the assets held in passive investments have more than doubled in the US. And according to the Investment Management Association, tracker funds’ share of total funds under management in the UK was 9.6 per cent in August 2013, compared with 7.9 per cent a year earlier.

Passive funds, like exchange-traded funds (ETFs), track market performance. ETFs themselves combine the best elements of index mutual funds with the trading flexibility of individual securities. Unlike open-ended investment companies and unit trusts, ETFs are listed on a stock exchange, which can offer investors better liquidity.

Used strategically, passive funds can boost an investor’s portfolio. Here’s how.

LONG-TERM PERFORMANCE
While they won’t outperform the market (the small fee means you will under-perform relatively), passive vehicles are often considerably cheaper than active funds. Indeed, Ben Smaje of Kennedy Black Wealth Management says that the longer the time horizon, the less likely an active manager is to outperform. Recent research carried out by rplan for The Telegraph supports this view. It found that £10,000 in a tracker fund with a 0.25 per cent fee will turn into £12,600 after five years; for a typical actively-managed fund, the result was £11,700. After 30 years, the gulf widens to over £40,000 for the tracker, compared to £26,000 for the actively-managed alternative.

But rplan’s research did find that sometimes a computer is no match for the human touch: one active fund, for example, grew by 224 per cent in the first five years, partly by investing in Aim-listed firms. Indeed, trackers invest proportionately to the size of the companies in the index they track, so may not offer meaningful exposure to other parts of the investment universe, like smaller companies.

SHORT-TERM EXPOSURE
The obvious attraction of a tracker vehicle is lower fees and simplicity – investors can quickly create a portfolio that covers the equity and fixed-income markets with a handful of ETFs. But Smaje thinks there is more to a passive approach than reduced costs. “Outweighing that is the fact that they give you greater control over the asset allocation process,” he says.

Indeed, they may appeal to a more sophisticated investor wanting to make short-term trades on a particular market. For exposure to the US economic upturn, Peter Sleep of Seven Investment Management points to the HSBC S&P 500 ETF, which costs 0.09 per cent a year. Alternatively, the iShares S&P 500 UCITS ETF tracks the widely-followed S&P 500 index. If you’re looking for exposure to the UK stock market, the Vanguard FTSE UK Equity Index fund has an annual management charge of 0.15 per cent. The HSBC World Index Dynamic Fund, meanwhile, could be a good option for those seeking global diversification.

NARROW MARKETS
Sleep also thinks passive vehicles are preferable in narrow markets, which lack variety and where it is very difficult for an active manager to outperform and earn their fee, like gilts or index-linked gilts. Similarly, Jason Hollands of Bestinvest says passive investments make sense in strongly rising and very efficient parts of the market, like US large caps or FTSE 100 stocks. He likes the Vanguard S&P 500 for US large cap exposure.

However, trackers are only as good as the indices they track. “Clearly, you don’t want to be tracking a falling index,” says Hollands.

THE YELLOW METAL
Passive strategies can be useful for allocating to asset classes such as commodities, where achieving physical exposure has historically been difficult for retail investors. The simplest and cheapest way to get exposure to gold, for instance, that doesn’t involve wearing it around your neck, is through a gold exchange-traded commodity (ETC). Their main advantage is their liquidity: “they can be sold any time in the day and you won’t have to worry about storage costs and insurance,” says Sleep. He lists the Physical Gold Source ETC, which is easy to trade and priced at 0.29 per cent a year.

But some investors may not be comfortable with their structure – unlike ETFs, they are not funds and they do not have to comply with UCITs requirements. If so, Smaje recommends the Lyxor ETF Commodities Thomson Reuters/Jefferies CRB ETF, which he has in his own portfolio. It offers investors good exposure to commodities (incorporating energy, metals and agricultural commodities), and has a total expense ratio of 0.35 per cent per year.

A STABLE INCOME BASE
Gilts may not be the most adventurous investment, but they are popular among investors in search of a safe, fixed income. Gilt trackers all follow the main gilt index, which has a duration of around nine years and can be volatile. So Sleep recommends investors look at those ETFs that invest in gilts with much shorter – or much longer – durations, so they can be more selective in which gilts they buy. He likes the SPDR Barcap 1-5 Gilt ETF, which is priced at 0.15 per cent a year and is easy to buy and sell. But while ETFs offer greater flexibility, be aware that tracker funds will avoid the small brokerage charge that can eat into returns.

There are a number of downsides to a uniquely passive investment approach, not least missing out on a manager’s expertise and ability to pick obscure stocks in more volatile markets. As such, Hollands finds the active versus passive debate “unnecessarily polarised. Each approach has its own time and place in a portfolio, but neither is a panacea,” he says.