Cheap core passives for your Isa

In 2014 net retail sales for tracker funds were up from £2bn to £4.9bn and made up 11.2 per cent of the industry total, according to data from the Investment Association. Added to that, the global exchange traded funds (ETFs) industry reached a new record level of $2.79 trillion, according to research by consultancy ETFGI, with net new asset inflows in December proving the largest on record.

Why go passive?

Index tracker funds and exchange traded funds both offer passive exposure to an index of shares for a very low cost. Bar a few exceptions, the price tag on a passive fund is generally far lower than on an actively managed fund.

Patrick Connolly, a certified financial planner at Chase de Vere, says: "I can understand why passive funds are growing in popularity. Many active funds underperform and charge more for it, so if you are not confident about getting outperformance with an active approach then it makes sense to invest passively, which will be cheaper.

"We tend to use them in more efficient markets, so large-cap UK and US equities. We use passive strategies very rarely in other areas because we have confidence that in those areas an active approach will outperform."

There are key differences between ETFs and tracker funds when it comes to buying your Isa through a platform, mainly in availability and pricing. Which you choose to use will depend on the kind of asset you want to track and where you can buy it.

In general, tracker funds are focused on core equity markets, while a proliferation of indices has sprung up around ETFs, enabling them to track a wider range of markets and assets.

The two are also priced and traded differently: ETFs are bought and traded on the stock market like shares, meaning their price fluctuates throughout the day according to supply and demand, while index trackers are priced once a day based on the net asset value (NAV) of the underlying securities.

ETFs will also incur dealing charges on platforms, which can make them costly for small regular savings, whereas tracker funds do not. But not all platforms will offer the ETF you want, despite the fact there are actually far more products on offer than trackers.

Lee Robertson, founding director of Investment Quorum, says: "We tend to prefer ETFs to tracker funds as they tend to be cheaper and we think they are more efficient and give you a better portfolio blend."

Shaun Port, chief investment officer at Nutmeg, says: "While some index funds can be cheaper than ETF equivalents, tracking performance tends to be better for ETFs. For example, Fidelity UK index fund costs 7 basis points (bps) but the tracking difference was 0.24 per cent last year. SPDR's FTSE UK All Share ETF (FTAL) costs 15bps, but the tracking difference was 0.11 per cent."

PASSIVE BUILDING BLOCKS FOR YOUR ISA PORTFOLIO

Growth

Vanguard FTSE 100 UCITS ETF (VUKE) is one of the cheapest ways of gaining access to the FTSE 100 at a cost of just 0.09 per cent. It is a physical ETF that fully replicates the benchmark, meaning it is heavily concentrated in financials and overweight major global corporations such as Royal Dutch Shell and BP. However, when mixed with other major market trackers this will form a good core holding.

The HSBC FTSE 250 Index fund (GB00B80QG052) could be a good fund to hold alongside VUKE, containing more young and growing companies than the FTSE 100. It comes with an annual charge of just 0.17 per cent and is higher up the risk scale, but the index has outperformed the FTSE 100 and FTSE All-Share substantially over the past 10 years.

The US is also an efficient market where active managers struggle to add value. iShares Core S&P 500 UCITS ETF (CSP1) is very competitively priced at 7bps per year. It is a cheap way of gaining exposure to large-cap US equities, which are predominantly weighted towards the technology, healthcare and financial sectors.

Income

It is worth looking at the range of passive funds focused on high-yielding companies. SPDR S&P US Dividend Aristocrats UCITS ETF (UDVD), a member of the IC's Top 50 ETFs, uses new 'smart-beta' technology, aimed at filtering out certain aspects of a major index. The fund's index tracks S&P 500 equities that have increased dividends each year for at least 20 years, as opposed to purely focusing on yield. It has an ongoing charge of 0.35 per cent.

The iShares UK Dividend UCITS ETF (IUKD) is focused on the 50 highest-yielding UK stocks. It is a broadly diversified, large- and mid-cap-focused fund with an ongoing charge of 0.4 per cent and yield of 4.29 per cent. But be aware that the fund has a 35 per cent exposure to financials.

Among tracker funds, consider Vanguard FTSE UK Equity Income Index (GB00B59G4H82), which targets the range of large, medium and small-cap companies within the FTSE UK equity income index. It has an ongoing charge of 0.22 per cent and a yield of 4.2 per cent.

Wealth preservation

Bonds have typically been the route to wealth preservation, but there is always the risk that interest rates will rise and bond prices will fall, with longer-dated bonds the most at risk.

Think about a fund of low maturity bonds which are less sensitive to interest rate changes, says Adam Laird, head of passive investments at Hargreaves Lansdown. iShares £ Corporate Bond 1-5 Year UCITS ETF (IS15) is cheap - at 0.25 per cent - and offers exposure to short and medium-dated maturity segments of the GBP-denominated corporate bond market. The fund has closely tracked its benchmark since inception, delivering a return of 21.19 per cent, against 22.45 per cent for the benchmark.

For products at the opposite end of the spectrum look to iShares £ Index-Linked Gilts UCITs ETF (INXG), a government bond with inflation-proofing built in biased to very long-dated maturities. It comes at a cost of 0.25 per cent.

Diversification

One of the main plus points of passive investing is the element of diversification it injects into your portfolio and if you choose trackers following a range of markets you will automatically have diversified your investment. However, if you want to be diversified across asset classes as well as sectors and geographies it is worth taking a look at Vanguard's LifeStrategy range, which mixes equities and bonds in fixed proportions and then automatically rebalances them to keep in line. There are four funds in the range which span risk scales and offer income or growth through a mixture of stocks and bonds. Vanguard LifeStrategy 40% Equity (GB00B3ZHN960) has an ongoing charge of 0.24 per cent and an initial dilution levy of 0.1 per cent and invests in a mixture of funds and bonds.

Contrarian bet

If you want a contrarian bet in your passive portfolio which also doubles up as a diversifier, commodities could be one of your best options. Commodities are by no means a stable play and without a clear hunch about a commodity or a real desire to take a bet on share prices, the best route could be through a broad-basket option such as db X-trackers DBLCI OY Balanced ETF (XDBG). It is based on futures contracts rather than physical products, making it a more complex product and it is more expensive as a result, with a 0.65 per cent ongoing charge. But you are paying for its smart-beta method, which aims to reduce the distortion on returns inherent in derivatives trading, so in comparison to peers it could be worth the price tag. "If you are in for the medium to long term and you believe the world will recover then I would recommend commodities," says Mr Robertson.

Mr Laird also recommends iShares MSCI Canada UCITS ETF (CSCA). "Canada is often forgotten by investors, who opt for their larger neighbour," he says "Recently UK investors have seen losses on Canadian investments due to a weakening Canadian Dollar - the loonie has fallen against GBP due to the falling oil price (oil is a major export for Canada) and a surprise interest rate cut in January.

"But there's a lot to like about Canada - it's a resource-rich country with good economic profile: low unemployment and good growth. It's also strong in technology and finance." CSCA is available at a charge of 0.48 per cent.

Cumulative performance against benchmark indices (percentage total return)

Source: iShares, DB Asset Management, TrustNet, Vanguard. All data rebased to GBP

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