Passive funds were once a minor part of the UK's investment landscape but are now a major element. A decade ago, passives accounted for just 9% of the UK retail assets under management, but this has grown to 22% today, according to data from the Investment Association.
This year that trend has continued: passive funds account for 128% of total net retail fund flows this year, overshadowing active funds with their £2bn outflow (which took 28 percentage points off the total).
Laith Khalaf, head of investment analysis at AJ Bell, said: “Personal investing has been transformed over the past 20 years and the proliferation of passive funds has been one of the key contributing factors.”
“Characterised by their low fees and simplicity, passive funds provide investors with an effective way to gain diversified exposure to various asset classes and market themes, and are used by novice and experienced investors alike.”
Below, Khalaf outlines six key considerations for investors looking to build a passive portfolio.
Risk, objectives and asset allocation
The foundation of any passive portfolio is to assess risk tolerance and investment objectives to ensure an investor can reach their goals.
Khalaf said: "How much risk you wish to take will determine how much to invest in shares, and how much to invest in bonds.
“An adventurous, younger investor might choose to invest 100% in stocks, whereas someone approaching retirement might feel more comfortable with a portfolio that is split 60% in favour of shares with 40% in bonds for some ballast to smooth out market volatility.”
Investors can either buy individual stock and bond trackers or find a ‘one-stop-shop’ fund that invest in both with a passive approach.
This step will also allow an investor to determine if a purely passive portfolio is right for them. Those who are simply after growth might find a portfolio of index trackers is pretty straightforward to pull together.
However, investors who are seeking a regular income stream or want exposure to more specialist assets not served by trackers, such as smaller companies, might need to consider active funds.
“There’s no harm having a mix of active and passive funds in the same portfolio in any case,” Khalaf added.
Regional equity diversification
Diversifying across regions is crucial but challenging, given the lack of a 'right' answer. Khalaf said investors could just put their money into the global stock market, allocating more to bigger companies.
“This is effectively what a global tracker fund would do, so you could just buy one of these,” he explained, adding that the benefits of this approach include simplicity, not needing to rebalance and knowing your performance will essentially match the global stock market.
However, this approach would lead to more than half of an investor’s portfolio being in US stocks. Investors who want to avoid this could invest a fifth each of their portfolio in the US, the UK, Europe, Japan and emerging markets.
“This adds some balance in terms of where your risk and reward are coming from and you can use it as a baseline for making active regional allocation decisions if you so wish, boosting exposure to one area you have confidence in at the expense of another you think is a bit of a dog’s dinner,” Khalaf said.
Index selection
Choosing the right index to track is a critical step so Khalaf emphasised the importance of understanding the benchmark, especially for more niche or thematic trackers.
“You should familiarise yourself with how the index is constructed so there are no nasty surprises along the way,” he advised.
Tracking difference
The tracking difference, or the performance differential between the fund and its benchmark index, should be minimal in a passive fund. While most of the big passive providers will have a similar tracking difference, investors should still keep an eye on it.
“You want this to be as small as possible,” Khalaf said.
Charges
Fees are paramount in passive investing as a tracker will underperform the index each year by the level of fees it levies, even if it is tracking the benchmark perfectly.
“Most tracker funds are keenly priced, but there can be some surprisingly expensive options out there. The cheapest UK tracker fund costs just 0.05% per annum, while the most expensive charges over 1%,” Khalaf warned.
Unit trust vs ETFs
Finally, investors must decide between ETFs and unit trusts. ETFs are more liquid, because they can be bought and sold instantly during the trading day, while unit trusts work on a forward pricing basis so it takes up to 24 hours to sell your investment.
“This makes ETFs more suitable for hobbyist investors who are tactically moving their portfolio around a lot and want to try to capitalise on short-term market fluctuations,” Khalaf said. “A unit trust trade will take place up to a day later at the beginning and a day later at the end of your investment period than the equivalent ETF.”
However, Khalaf explained that, for long-term investors, the difference is minimal so the choice should be based on individual trading preferences and investment duration.