Passive plays for your portfolio

Patrick Connolly, of independent financial adviser (IFA) AWD Chase de Vere, says: "We will see even greater demand for passive funds following the implementation of the retail distribution review (RDR) next year, when charges will become more transparent and there will be extra focus on proving that higher charges on actively managed investment funds are justified. The reality is that people will see that many active management charges cannot be merited."

The total annual cost of an actively managed fund averages 1.5 per cent, compared with 0.7 per cent for a FTSE tracker fund. However, passive funds, such as trackers and exchange-traded funds (ETFs), which track indices and particular assets, might not outperform some of the best actively managed funds over the long term, as figures from IFA Chelsea Financial Services demonstrate.

If you had invested £10,000 in Axa Framlington's UK Select Opportunities fund 10 years ago - one of the best performers, with a 1.5 per cent annual charge - it would be worth £29,229 after fees today. This compares with £20,415 for a typical passive fund tracking the FTSE All-Share charging just 0.5 per cent a year.

While there is no guarantee that an active fund will beat the relevant index - the vast majority don't - index-tracking funds also have their pitfalls. Mr Connolly says: "It is important to understand that, even for a passive find, cheapest is not always best. Different passive funds use different techniques to track their target indices and, if their strategy is not effective, then a passive fund can potentially underperform.

"If you have selected a passive investment then the key is to check how accurately it tracks the index that it is supposed to be following. If a passive fund significantly outperforms the index this suggests that its tracking techniques aren't very accurate and so there is a risk that it could significantly underperform in the future."

The average passive fund tracking the FTSE All-Share index has returned 13 per cent after fees over the past year, compared with 15 for the index itself, according to data from Morningstar.

Adrian Lowcock, from IFA Bestinvest, adds: "Some tracker funds only invest once a month, but use derivatives to get exposure inbetween, creating discrepancies between performance and benchmark returns.

"Others carry out stock lending, whereby they are holding a significant amount of a company's shares for the long term but loan it to other investors for short periods, and charge a fee to them for doing so. This can help reduce the impact of costs, but can add risk to the fund.”

However, a passive approach can have its attractions if you choose wisely, and there is an array of trackers and exchange-traded funds (ETFs) to choose from.

Trackers vs ETFs

Tracker funds are open-ended funds such as open-ended investment companies (Oeics), while ETFs are listed on a stock exchange like a share. Tracker funds are usually available from platforms or providers without an initial fee.

By comparison, ETFs are bought through a stockbroker so you have to pay the broker's dealing charges, which typically fall between about £10 and £30 per trade depending on whether you use online or telephone dealing.

We looked at five key areas where you may wish to use a passive fund in your portfolio: FTSE 100, FTSE All-Share, S&P 500, emerging markets and alternative assets.

HSBC tracker funds are typically picked out as some of the best options for the UK markets owing to their rock-bottom costs. Mr Connolly says: "In general we tend to like these funds tracking the major markets, as they have low costs and low tracking error."

They are certainly among the cheapest. The HSBC FTSE 100 Index fund, for example, has a TER of 0.27 per cent and no initial charge alongside a good tracking record; over three years it made 37.2 per cent while the FTSE 100 index made 36.9 per cent.

However, Darius McDermott from Chelsea Financial Services says: "For the UK market we would advocate the use of a FTSE All-Share tracker as different parts of the market outperform at different times." When it comes to the FTSE All-Share, a top pick is the L&G UK Index fund, with a TER of 0.23 per cent. Over three years it made 39.4 per cent, compared with 38.1 per cent for the index.

For investors wishing to track the US market, a preferred option is the Vanguard US Equity Index, which tracks the S&P Total Market. Mr Connolly says: "Vanguard is hugely experienced at running passive investments in the US market and offers low charges." This fund made 55.9 per cent over three years, compared with the index's 57.1 per cent.

The L&G Global Emerging Markets Index is a good option for emerging markets, says Mr Connolly, as one of few experienced passive managers offering diversified emerging market tracker funds. But the fund fell 1.37 per cent over the past 12 months, while the index made 0.14 per cent, and active managers have traditionally outperformed in this sector.

Andy Parsons, head of investment research at The Share Centre, says: "We are often led to believe that stock markets are efficient, and if this holds true the argument for passive investing and an index fund would suffice.

"However, as we have seen over time, not all markets are efficient and valuation anomalies do occur; it is for these reasons that the argument for active management persists. Personally, I believe there is a place for both, depending on the investment objective of the investor."

Constructing a balanced, diversified portfolio through trackers and active funds is an option. However, also consider how these funds are held. Investors opting for a tracker should check that these funds are available through an individual savings account (Isa) wrapper, as a tax-efficient method of holding these funds.

Index-tracking funds - the full list

Source: Morningstar as at 10 August 2012