From keeping costs down to looking under the bonnet, this is how to successfully invest passively.
At first glance, passive funds are simple. They track a basket of stocks, such as a global or UK market index, and charge investors a low fee for the privilege.
But the growing popularity of the approach – which accounts for 19% of retail investor assets – has led to a proliferation of new passive strategies. This means investors are spoilt for choice, something that brings many opportunities but also pitfalls to watch out for.
These are our top 10 tips to investing in index funds and exchange-traded funds (ETFs).
Do not overpay
Investment management firms charge different amounts for the same product, so doing extra research on the cheapest funds available can deliver guaranteed savings.
For example, BlackRock’s iShares Core FTSE 100 ETF (LSE:ISF) costs just 0.07% in annual fees, but the Lyxor Core UK Equity All Cap ETF (LSE:LCUK) charges just 0.04%, making it one of the cheapest ways of buying UK stocks.
On the other end of the spectrum, the Halifax UK FTSE 100 Index Tracking Fund costs 1.05% and the Marks & Spencer UK 100 Companies costs 0.5%. All these funds track the performance of the largest 100 UK stocks, but some charge more than the typical actively managed fund (which tend to charge around 0.75% to 0.85%), where investors pay extra for a fund manager to try and beat the market.
Percentage fees lull investors into a false sense of security. They appear small, but over the long run can significantly add up in pounds and pence – particularly in this instance.
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For example, let's assume that over a 25 -ear period both the Lyxor Core UK Equity All Cap ETF (LSE:LCUK) and the Halifax UK FTSE 100 Index Tracking Fund deliver the same returns – 5% a year. A lump sum of £10,000 is invested. The Lyxor Core UK Equity All Cap ETF (LSE:LCUK) would give the investor £33,543, with just £321 taken for the fund fee. The Halifax UK FTSE 100 Index Tracking Fund, in contrast, will have grown to £26,340, with £7,523 absorbed in the higher fund charge.
Look under the bonnet of a strategy
While price matters, it is essential to look at the index a passive fund tracks as there can be key differences between similarly labelled funds.
The iShares MSCI ACWI (LSE:SSAC) and the iShares MSCI World ETF (LSE:IWRD) may look the same, but they own different companies. The former is an “all country” tracker, which includes emerging markets stocks, while the latter just owns those from the developed world.
Investors could also be tripped up by ethical passive funds that own stocks that might not meet their own responsible investment standards.
Vanguard’s ESG Developed World All Cap Equity Index Fund owns Meta (NASDAQ:FB) (Facebook), a company which some people may not agree with. Other ethical passive funds own oil companies that are investing in renewable energy.
Check if a fund is market cap or equally weighted
While most passive funds are “market cap” weighted, which means they buy more of a company as it grows larger, some are “equal” weighted, with each company making up the same proportion of a fund.
What may appear a cosmetic difference can have serious consequences for performance. The dominance of America’s largest technology companies over the past decade has meant that funds that bought more of them as they grew larger performed best.
A regular S&P 500 tracker has made 80% over five years, while an equally weighted one has made 56%. However, as cheap stocks make a comeback and big expensive ones falter, buying an equally weighted fund might now reward investors.
Check how closely a fund follows its index
Buying a fund that closely tracks its index is another important consideration. There are two measures: tracking difference and tracking error.
Tracking difference is the drag on performance produced by things such as management fees, rebalancing costs, cash drag and dividend distribution.
Tracking error is a calculation that looks at the consistency and volatility of the difference between a fund and its benchmark over time.
Either way, a large tracking error or tracking difference should be seen as a red flag by investors. Large errors or differences potentially signal that the ETF in question incurs excessive trading costs (perhaps due to the complexity of its strategy) or the asset management firm running the ETF is charging high fees.
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Make sure you understand industry jargon
Thematic, factor, ESG, synthetic: the passive investment world is full of industry jargon that can lead investors into the wrong fund.
Taking the time to read about a strategy and truly understand it is essential. Factor funds, also known as smart beta funds, can be particularly tough for beginner investors to get their heads around.
Such funds buy stocks that display certain characteristics, such as cheap share prices relative to earnings, or above average dividends yields. This allows investors to cheaply replicate an investment style.
Check our ETF jargon buster to get to grips with all the lingo.
Watch out for expensive thematic funds
A growing area for passive investment has been “thematic” funds, which buy companies involved in niche business areas, such as artificial intelligence or clean energy.
However, some of these hot strategies charge investors even more than an active manager would, which is a potential red flag for investors if the fund does not deliver the goods.
For example, the EMQQ Emerging Markets Internet & Ecommerce ETF (LSE:EMQQ) charges 0.86% and the Medical Cannabis and Wellness ETF (LSE:CBDX) charges 0.8%.
Check if a tracker owns physical assets or financial contracts
A physical ETF buys the shares of the underlying index it is supposed to mirror. In contrast, synthetic ETFs do not physically own companies, bonds or commodities, but instead buy financial contracts that replicate the price of them.
This means that investors can pay less for the funds, but may run into a trouble in a financial crisis if the bank that provides the derivatives collapses. This is known as counterparty risk.
Investors in gold should pay extra attention to this. While some funds, such as Invesco Physical Gold (LSE:SGLD), buy gold bars, others just track the price of gold.
Be careful with bond tracker funds
Unlike stock market passive funds that tend to buy more of companies as they grow larger (and more successful), bond funds have their biggest positions in companies or countries with the most debt.
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This could be interpreted as a reason not to invest, as companies with more debt may be less secure financially. For example, Estonian bank Luminor is in the top 10 holdings in Vanguard’s Global Corporate Bond Index .
On the other hand, active funds can avoid companies that are heavily in debt and focus on more financially secure firms.
Don’t use index fund for short-term trading
ETFs are listed on stock exchanges, which means investors can trade shares when markets are open. This is great for those who want to quickly move in and out of an investment.
However, index fund trades are typically executed once a day, so investors face short delays for their trades to go through. While not an issue for long-term investors and regular savers, day traders are better served by ETFs.
Be careful with Leveraged ETFs
Leveraged ETFs give the investor multiple times the return of the index. The WisdomTree FTSE 100 3X Daily Leveraged ETP (LSE:3UKL), for example, provides triple the daily return of the FTSE 100.
Investors should be careful here, as although there are potential gains to be made, they could experience huge losses too. The promotional literature of many leveraged products specifies that they should not be held for more than one day due to this.
Leveraged ETFs are not suitable as long-term investments. Our article below explains why in more detail.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.