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Constructing a passive portfolio

You can construct an entire portfolio of exchange-traded funds (ETFs). However, for exposure to certain markets a tracker fund might be a better option
June 11, 2010

There's a well established investment philosophy which says that although actively managed funds, dependent on research and the preferences of their managers, may beat the wider stock market over a year or two, very few are able to maintain outperformance over the long term - and that it therefore makes more sense for investors to construct portfolios from cheap, passively run funds that track their chosen market index rather than trying to outpace it.

If that's your starting point, then there are two obvious types of investment to consider: index tracker unit trusts or oeics, and exchange-traded funds (ETFs). Both provide low-cost access to the full market, without the need to rely on fund managers' judgements about individual stocks.

What are the arguments in favour of each option? ETFs replicate the market index in the same way as a tracker, but can be bought and sold throughout the day on the stock exchange, like a single company share. "With a unit trust, trading takes place once a day - if you have to wait until the next day for your trade to go through, the price may have moved. In contrast, ETFs are transparent, in that you can trade minute by minute at the price you see," explains Graham Spooner, investment adviser at broker The Share Centre.

Clearly, having an online share-dealing account makes the ETF process particularly swift and simple. "In both cases you're buying the market, but we prefer ETFs simply because of ease of trading," adds Stuart Fowler, managing director of independent financial adviser (IFA) No Monkey Business.

Cost considerations

Given that most people building a fund portfolio are taking a relatively long-term view of their holdings, trading costs is perhaps a less significant consideration than it is for more active traders using ETFs tactically to dip in and out of markets.

Arguably more significant are cost considerations. Compared with actively managed funds, ETFs have very low running costs, which means less drag on performance. That is because they are run largely by computer rather than by an expensive active manager; additionally, index tracking investments generally involve less buying and selling of share holdings than active management, thereby keeping transactional costs down within the fund.

Thus, according to iShares, the average total expense ratio (TER) for a bond ETF is 0.25 per cent, and for an equity ETF it's 0.32 per cent. In contrast, TERs for actively managed UK equity funds are around 1.5-2 per cent, according to Investment Management Association figures. Even the standard index tracker funds available through the retail market have average TERs of 0.8-0.9 per cent (although John Lang, director of financial planning firm Tower Hill Associates, points out that intermediaries can now access very cheap tracker funds from Vanguard at around 0.15 per cent).

Nor are there any incidental charges to rack up along the way - stamp duty is not payable on ETFs as it is on shares. However, ETF dealing costs do need to be taken into account - particularly on smaller sums. Most online brokers offer execution-only trades for around £10 to £15, which on a trade of, say, £20,000 makes no significant difference. But if you're buying only £500 of ETFs, that £15 dealing fee amounts to an extra cost of 3 per cent.

Dennis Hall, managing director of Yellowtail Financial Planning, uses both trackers and ETFs, depending on the market to be followed and the price on the day. "For instance, to track the FTSE we'd use an L&G or HSBC tracker because they are cheapest, but in more esoteric markets such as Brazil, an ETF is definitely cheaper than any unit trust," he says.

Swaps or traditional replication?

Another issue that prospective portfolio builders need to be aware of is that not all ETFs work in the same way. Some, including all those available from iShares, are known as cash-based or physical ETFs; they work like a unit trust, basically replicating the index using physical shares. Alternatively, in some cases where the index is too big, it may be more practical for cash-based ETFs to hold a representative sample of index constituents, rather than every single holding. The iShares MSCI World ETF, for example, holds just 700 securities of the 1,800 in the MSCI World index.

But other ETFs, particularly those following more esoteric markets, take a different route, using total return index swaps to mirror an index's movements. As Mr Fowler explains: "This means that the ETF manager does not hold any physical stocks, but instead holds other assets as collateral and swaps the return on that portfolio with the return on the index being tracked."

Swap-based ETFs can be more tax-efficient in some cases; they can also reduce tracking error - the (usually) small but inevitable underperformance of any index-tracking fund relative to the index itself, because the full index return is guaranteed by the counterparty to the swap. However, cautions Mr Lang: "Swap-based funds are deemed less transparent, and also more risky because of the counterparty risk involved." He recommends that newcomers to ETFs should start with a replicated index.

"It is important to assess all ETF products and their structures (physical or swap) when making an investment decision, as each has its own unique exposure, risk and tax implications," adds Nizam Hamid, head of sales strategy at iShares.

Spoiled for choice

If you plan to build an entire portfolio from ETFs, you have tremendous choice in both fixed interest and equity products. There are equity ETFs tracking regional indices, single emerging markets, industrial sectors such as banks or telecoms, themes such as clean energy, and specific market capitalisations, as well as specialist ETFs providing short or leveraged positions in particular indices.

John Lang explains that the first issue in creating a portfolio is to establish the client's age and attitude to risk, so as to determine the proportions of fixed interest and equity ETFs; then the equity portion can be spread geographically using regional ETFs.

"We would put, say, half into a FTSE All Share ETF; then there is a Developed Countries ex UK product that could be used to get exposure to the US, Europe and Japan with a single fund; and we'd also put maybe 10 per cent into an Emerging Markets ETF," he says. "A simple global portfolio of bonds and equities could be constructed with just five or six ETFs."

Once you have decided where you want to invest, how to choose specific ETFs? The UK market is dominated by iShares, but db-xtrackers (from Deutsche Bank) and Lyxor (from Societe Generale) also operate here. There is often a choice of funds doing much the same thing, so it's worth comparing charges between different providers, as they may differ for the same index.

A balanced ETF/tracker portfolio
FundPercentage
HSBC FTSE 100 Index 14%
HSBC FTSE 250 Index6%
iShares FTSE UK Dividend Plus Index 10%
iShares MSCI World11%
iShares MSCI Emerging Markets 5%
iShares FTSE All Stocks Gilt Index 25%
iShares £ Index-Linked Gilts 20%
iShares FTSE EPRA/NAREIT UK Property Fund 9%

Source: Yellowtail Financial Planning

Notes: For a 'balanced' investor, Zac Ghadially at Yellowtail suggests the eight-holding ETF portfolio above, which includes a mix of fixed interest, property and globally diversified equities. However, he makes the point that because his firm can access attractive institutional prices on some funds, a 'real-life' portfolio might look rather different.