Passive investing is not risk-free however; there are just as many rubbish tracking funds as there are good ones, and more complex choices such as ETFs are also fraught with danger if you fail to keep your wits about you.There are a few key things to look for, however, which should make it relatively straightforward to find the low-cost market performance you are looking for.
The obvious thing to look for is cost. The main advantage of a passive fund is that it is relatively straightforward to run and should not cost much.
This, however, is not always the case. Passive funds in the UK, especially those aimed at retail customers rather than big institutions, have not been particularly competitive until recently, and there are many examples of tracker funds charging extortionate fees.
The Halifax UK FTSE 100 Index Tracking fund has a total expense ratio (TER) of 1.52 per cent.
This is phenomenally high for a supposed low-cost option, and while it is being singled out for being the worst offender, it certainly is not alone.
Henderson’s UK Tracker charges 1.27 per cent and L&G’s (N) Tracker charges 1.15 per cent.
Although it should be noted that it is harder and more costly to try and replicate the FTSE All Share index given the vast number of costs, the L&G fund charges a lot more than many of its peers.
Compare this to Threadneedle’s top-quartile UK Growth fund, which has a TER of 1.1 per cent, and you can see that these tracker funds really are not value for money.
Performance of funds vs index over 3-yrs
Source: FE Analytics
Focusing on cost alone is not enough, though. Tracking an index perfectly is expensive; it requires holding all the component stocks and constant trading to stay in line.
Tracking less closely can be a great way to save money but can have a detrimental impact.
Even trackers with a very low TER can significantly underperform their target benchmarks just through inefficient tracking strategies.
There is typically a trade-off between cost and tracking, both of which impact returns. For reference, a middle of the road UK tracker fund should be charging less than 1 per cent, much less if its tracking error is high – say above 3 or 4 per cent.
This trade-off has never really been that satisfactory and has been exploited with great success by the ETF industry.
ETFs offer extremely accurate index-tracking at a very low cost. They do this through the clever way in which they are designed, which effectively makes them self-managing, cutting out any expensive human interference.
Again though, ETFs are no silver bullet. Many of those available today rely on complex derivative strategies, which have significant risk attached to them, much of it hidden from view.
While the derivative markets behave sensibly most of the time, allowing low-cost efficient exposure to various equity markets, they do have the capacity to go seriously off-course.
This applies mostly to the wide array of exotic ETFs offering far more than simple market exposure, although there are complexity and transparency issues affecting even the most mundane offerings.
Complexity by itself is no bad thing, but it is important you know what you are getting yourself into – understanding, even at the most basic level what makes an ETF tick is a good sign; anything that does not make sense should be treated with caution.
For anyone with a bit of daring and a suitable trading account, index futures or spread betting can be a way of building your own tracking fund, as long as you resist the temptation to start speculating and avoid ramping up your exposure.
As most financial betting sites do not charge tax, this can be a good way to go, although it requires significant work.
The recent arrival of Vanguard in the UK, however, has provided a much-needed shot in the arm for the UK passive industry, making a DIY approach less appealing. The giant US passive specialist has launched a range of trackers with exceptionally low charges and near perfect replication.
Their advantage is the huge scale of their operation, which allows them to keep costs low. This means they are restricted to the larger markets and have little in niche areas. For this sort of exposure, ETFs are still a better bet.
For a UK equity tracker, charges in the 0.5 per cent range are really the highest you want to be paying, and performance below the benchmark of anything more than 1 per cent on top of what fees account for is systematic of poor tracking ability.
Take this into account and you will realise there really are not that many good funds available.
Vanguard's FTSE All Share tracker charges just 0.15 per cent and has lagged the benchmark by just 0.12 and 0.13 per cent over the previous two 12-month periods.
Compared with Halifax’s 1.5 per cent charge for the woeful return of 2 to 3 per cent less than the market every year, it is hard to justify looking anywhere else.
While there are other funds that can compete on cost, none of them can do so while still maintaining a close relationship with the index. The only thing that can come close is an ETF.
The rise of ETFs and new entrants such as Vanguard is a welcome development. Many providers, such as Halifax, have been complacent and able to get away with near daylight robbery due to the lack of competition and general disinterest that has surrounded trackers for years.
Hopefully the renewed interest in passive funds and increased competition will see the death of some of the worst performers and a more comprehensive set of options.
Investors can play their part too; passives are not the easy option, the same care and attention is required as when picking an active fund, and getting it wrong can be just as costly.