Wednesday 20 March 2019 7:55 am

The pros and cons of using your Isa savings to invest in tracker funds

With the 5 April tax deadline fast approaching, have you worked out where is best to invest your Isa savings?

If you haven’t, you might like to consider looking at passive investing. Also known as trackers, passive funds simply track what’s happening in big indices, such as the FTSE 100, the S&P 500, and the Dow Jones.

If you spend a lot of time staring at the stock market, thinking about what’s rising and falling, and how you can play the market for the best returns, passive investing probably isn’t for you. You’re never going to make whirlwind returns.

But they’re the simplest (and often cheapest) funds to invest in.

Although he admits that passive investing wouldn’t be his first recommendation, Ben Yearsley, director at Shore Financial Planning, says that “it’s better to invest than not at all”, adding: “Too many people, especially investment novices, say investing is too confusing, and prefer to just keep their savings in cash.”

Cheap and cheerful

Any investment you choose to make that follows the market will fluctuate. This is the nature of investing.

If you decide to use your Isa allowance to invest in passive funds, they will only track the indices, so be aware that you won’t be able to the beat the market. But if the market gains, so will you. And vice versa.

Darius McDermott, managing director at Chelsea Financial Services, says that trackers are really easy to understand: “If the market is strongly rising, they can do very well.”

He also points out that some passive funds will follow the markets more closely than others. For example, some will fully replicate the market. Others, however, will replicate the biggest stocks in an index, and assemble the smaller companies in the index into a “basket” of stocks, rather than using the exact weightings of the smallest companies in the index.

Also consider that there is nothing particularly passive about a passive Isa. You’re still making an investment decision, which is the most active thing you can do with your money.

The big benefit of tracker funds is that they are cheap, because there’s no asset manager trying to cherry-pick the right stocks for you.

With that said, also be aware that not all passive funds are inexpensive.

McDermott draws particular attention to the Virgin UK tracker fund, which has an annual management charge (AMC) of one per cent. That’s very high given that the average AMC for tracker funds is 0.33 per cent, according to Morningstar.

Yesterday’s story

One thing you do get with a tracker is guaranteed underperformance, warns Yearsley. “Because of the charges, your return will not match the performance of the index.”

McDermott describes passives as “yesterday’s story”, adding: “By their very nature, they invest in companies that have already done well or are popular, not those that will necessarily do well in the future.”

“A passive Isa will never outperform an index if they are a true tracker, because it will be index performance minus charges,” explains McDermott. “As an investor, you have to have exposure to all companies in the index, even if you think that they are badly run or unlikely to do well.”

And also there’s no altering your stocks if you feel like a business has made a bad decision.

Yearsley points out that it’s also impossible to be an ethical investor through passive products.

Regardless of what market they’re tracking, passive Isas will include weapons manufacturers and tobacco companies. Compare this to an active manager who can exclude those businesses, so it’s worth consider what’s important to you.

McDermott also points out that actively managed funds can beat the index if you find the right manager. “A good manager will consider the fundamentals of the individual company, the price being paid, and how much of a weighting a company should have in a portfolio.”

Silver lining

On the face of it, it can seem like there are more cons than pros when it comes to passive investing.

However, McDermott admits that sometimes passive is better. One example is the Global X Silver Miners exchange-traded fund (ETF), which gives exposure to silver, and can help to diversify a portfolio.

If you’re interested in the US markets, tracker funds like the Fidelity US Index are also useful, because it’s almost impossible to outperform parts of that market.

McDermott also offers a word of caution: “One area where we almost certainly wouldn’t use ETFs is the bond market because, by definition, you are buying the most indebted companies, which doesn’t sit well with us.”

Bear in mind, if you’re planning to invest, make sure your cash goes into regulated UCITS funds, which have safeguards to protect your cash.