Trackers for your Isa

Figures produced by the Investment Management Association (IMA) for the Investors Chronicle also reveal huge inflows of Isa money into actively managed funds, particularly into strategic bonds, global equity income and emerging markets. Advisers say active funds are better for investing in these three sectors than trackers, and believe investors allocating assets to them could help explain why passive funds were less popular last year. In total, Isa investors funnelled £149bn into actively managed funds last year.

Patrick Connolly, a certified financial planner at AWD Chase de Vere, was surprised by the figures as he said advisers are recommending passive funds more than ever due to their improving transparency and falling charges. Passive funds can be a great way to maximise the tax advantages of an Isa and Mr Connolly is confident 2013 will be a good year to invest in them.

Why include passive funds in my Isa?

Passive funds, also called index funds, mirror an index such as the FTSE 100. They are the opposite of active funds, where the fund's manager attempts to beat the market by buying and selling selected stocks.

One of the best things about them is that they are cheap. The total expense ratios (TER) of passive tracker funds are usually well below 1 per cent, compared with an average of around 1.6 per cent for a unit trust or open-ended investment company (Oeic). Low costs are important if you want to make the most of the tax efficiency of your Isa.

And countless pieces of research have also shown that passive funds consistently beat the average actively managed fund in a number of sectors as many active funds fail to outperform their benchmarks.

Many diversified portfolios will contain a combination of active and passive investment funds. You could, for example, hold active funds in sectors where the fund manager should be able to outperform, such as in smaller companies or emerging markets. But in markets where outperformance is less likely, large-cap UK and US equities, for example, passive funds are worth some consideration.

Do your homework

They might be a cheap option but don't be deceived by the simplicity of tracker funds. They're often seen as less risky than actively managed funds, but they come with risks of their own. That's why you need to get your head under the bonnet to see what's really going on before choosing passive funds for your Isa.

First of all you need to know what stocks are in the benchmark because, unlike actively managed funds which are able to adjust to cope with a market crash, a tracker fund will go down with the index. And, just like active funds, passive funds also come with hidden costs. Providers don't go around shouting about these so you need to do your homework. Some funds track their index better than others so check the tracking difference and the tracking error as well as the TER.

Ben Yearsley, head of investment research at Charles Stanley Direct, says you should not invest in a passive fund if it has a TER of more than 0.2 per cent because it's too expensive. "Cost is a vital consideration so make sure the passive funds in your portfolio are actually cheap," he says. Other advisers' favourite funds are up to twice as expensive as this, but none of the following recommendations has a TER of over 0.5 per cent.

Passive building blocks for your Isa

If you're constructing your portfolio for the first time you need some solid funds to start your portfolio.

Ben Seager-Scott, senior research analyst at Bestinvest, recommends avoiding exposure to bonds through passive funds because they are dictated through the market and says they haven't done as well recently. He also advises wariness of anything tracking a European index because of their high level of banking stocks with uncertain futures.

HERE ARE FIVE SOLID FUNDS TO CONSIDER:

10. HSBC American Index Fund

(ISIN: GB0000470418)

There's no such thing as a 'safe' index to track but the S&P 500, based on the market capitalisations of the 500 leading companies publicly traded on the US stock market, is about as close as you're going to get. It has done well over the long term, making it a key building block for your portfolio, but you need to plan on buying and holding for a number of years. HSBC's American Index fund comes highly recommended and has a TER of just 0.10 per cent. iShares also has an S&P 500 exchange traded fund (ETF), but with a TER of 0.40 per cent it looks expensive. Advisers have been pressurising BlackRock, which manages the fund, to lower its price and an off-the-record source told Investors Chronicle they are confident the fees will plummet by the end of the year. This could be one to keep an eye on then.

11. Vanguard FTSE UK Equity Index Fund

(ISIN: GB00B59G4H82)

Vanguard's FTSE UK Equity Index fund charges a total expense ratio (TER) of a mere 0.15 per cent a year - a fraction of what UK investors are used to paying on UK tracker funds. The fund prices at the end of the day so volatility is lower.

12. HSBC FTSE 100 Tracker Fund

(ISIN: GB00B80QFR50)

A FTSE 100 tracker is a solid building block for any portfolio. HSBC's offering is about the cheapest on the market and comes highly recommended. The FTSE 100 has rocketed since the start of 2013 and traders sent it climbing above 6400 for the first time in five years thanks to market optimism following the release of the Bank of England minutes earlier this month.

But investment experts are divided when recommending it as an index to hold in your Isa - while some recommend it to clients, others say it is too concentrated. Just three sectors: oil and gas, financials and mining make up half the index so make sure you are happy with this before you invest.

13. iShares MSCI World ETF

(ticker:IWRD)

If you want exposure to global growth try iShares MSCI World. This fund is a physical ETF that aims to track the performance of the MSCI World Index as closely as possible. The MSCI World Index offers exposure to more than 6,000 stocks from 24 developed countries worldwide which comply with MSCI's size, liquidity, and free float criteria.

The TER is high at 0.5 per cent, but sources say iShares is tipped to slash its management fees on several funds this year as competitors up their game on transparency and tracking error.

14. iShares Global Corporate

Bond ETF (ticker:CORP)

Corporate bonds are popular among investors. But passive options for exposure to corporate bonds are also increasing. The advisers we spoke to weren't keen on bond funds at all, but if you are set on popping one in your Isa, the iShares Global Corporate Bond ETF is a good option. It was the first global corporate bond ETF available to European investors and came at the end of last year when demand for fixed-income assets was soaring. Flows into fixed-income ETFs almost doubled in 2012, with $50.8bn (£33.53bn) of net new assets recorded in the first eight months, compared with $28.5bn in the same period in 2011, according to BlackRock's ETP Landscape research.