How to choose the right passive fund or ETF

Chioce of passive fund or ETF

Passive funds and exchange traded funds (ETFs) have historically been the easyJet options in the investment world: cheap, no-frills choices with widespread appeal.

They provide a useful way to access stock markets at low cost, for short periods or in areas where active managers struggle to deliver good returns ahead of an index.

However, passive funds have evolved over recent years. It is now possible to track everything from commodities to currencies to bonds. It is possible to take triple leveraged exposure on the oil price, for example, or go short on the S&P 500.

While such opportunities can bring nuance to a portfolio, they also expose as erroneous the assumption that passive investing is somehow more straightforward than active investing.

RESEARCH YOUR PASSIVE INVESTMENTS

For the time being, however, many investors clearly do not take the same care over their passive investments as they do over their active selections.

Andrew Walsh, head of UK ETF sales at UBS, says: 'People spend a long time investigating active managers. This is perhaps understandable, because the range of outcomes is quite wide. With passives there is a narrower distribution of outcomes, but there is some variation, and investors need to be alert to it.'

Even basic passive funds that replicate an index differ significantly. Cost has become the headline way for funds to differentiate themselves from one another; fund providers increasingly strive to shave a few decimal points from their annual management charge.

There has been a race to the bottom in which passive managers have used their increasing scale to drive down costs and cut out rivals.

The long-term drain of costs on an investment is well documented. Indeed, this has been one of the strongest arguments for passive investments. Certainly, passives are cheaper in many cases, but costs can sometimes rise, and investors need to be aware of this. The cost of buying a currency-hedged version of an ETF, for example, will be higher.

Morningstar gives the example of the iShares MSCI Japan currency-hedged ETF, which has a total expense ratio (TER) of 0.64 per cent, compared with just 0.48 per cent for the unhedged version.

Equally, the cost of replicating more esoteric markets and indices will be higher. In fact, the costs of some smart beta or 'active' ETFs can be almost as high as those of active funds.

That said, for most vanilla flavoured passive funds - although it may be heresy to say so - the costs are low, and a decimal point or so of difference probably won't have a significant impact on your investment over the long term.

Petronella West, private client director at Investment Quorum, says: 'The one rule is that they should be as cheap as chips.' However, all other things being equal, the difference between £10,000 invested in a fund that charges 0.5 per cent and one that charges 0.4 per cent is £182 over 10 years. Other factors are likely to have a larger impact on overall returns.

OTHER CONSIDERATIONS

Tracking error is an important consideration, as it will vary depending on how managers choose to replicate an index, rebalance the portfolio and reinvest dividends. It will also depend on the timing of reinvestment and a myriad other factors.

Trackers may use physical replication (buying stocks in the same proportions as those in the index, so that performance matches that of the index) or synthetic replication (using a derivative provided by an investment bank to guarantee the index performance).

Physical replication has proved more popular, even though it will often have greater tracking error.

Synthetic replication is thought to introduce more counterparty risk - the investment bank may go bust, for example, leaving investors relying on the collateral used to support the derivative deal - but this is more of an issue when there is a wider threat that investment banks may default.

However, West says: 'In practice, counterparty risk is unlikely to be a significant issue for investors who are buying from major passive providers such as Deutsche Bank or iShares.'

Nevertheless, Justin Oliver, chief investment officer at Canaccord Genuity Wealth Management, prefers physical trackers over swap-based alternatives, believing them to be more transparent.

Physical replication can be more difficult in less liquid markets, such as smaller companies. A fund tracking a smaller companies index may employ 'sampling': rather than buying every stock in an index, it may buy a selection of stocks that will have the same effect. This may introduce greater tracking error.

Equally, the extent and timing of the rebalancing of a fund's holdings can introduce tracking error. A stock's weighting in an index will change over time as its share price changes and the passive fund provider will have to rebalance the fund to match that, but may not do so instantly.

COMMODITY-BASED ETFS

While tracking is an issue for all passive funds, the problem is particularly acute for commodity-based ETFs.

For example, at the moment it might be tempting to believe that the oil price has reached a nadir and should rise from here. An oil ETF might seem a reasonable way to express that view in a portfolio.

However, Gavin Haynes, investment director at Whitechurch Securities, points out: 'Commodity ETFs do not simply track the price up and down. There are complexities in the way they are structured that investors need to be aware of.'

They may, for example, track the futures market, or the shares of commodity production or services companies. However, none of these will directly match the price of the commodity.

David Coombs, head of multi-asset investment at Rathbones, agrees: 'Oil ETFs are not linked to the spot price of oil. While they can seem like a good way to take positions, investors may not get what they expect.' In preference, he has bought a Mexican ETF, reasoning that the fortunes of the largest companies in Mexico are linked to the oil price.

There are also differences in the structure of different types of passive fund, which affect how much they cost and how they are bought and sold. Haynes says: 'ETFs have real-time pricing, whereas a unit trust or Oeic is only priced once a day.'

The appropriate choice may depend on how an investor will use a fund. If an investor wants short-term exposure to a market, an ETF may be the right solution. But an open-ended tracker fund might be better for those taking a longer-term view.

Haynes points out that choosing between an ETF and a tracker unit trust or Oeic will have cost implications. He generally prefers unit trusts/Oeics because no stockbroking fees are charged. Investors' costs will depend on the fees charged by platforms, the frequency of trading and the annual management fee on the ETF compared with that on the unit trust.

The biggest consideration for investors in the selection of a passive fund is whether it is appropriate for their investment needs - a concern that can get rather lost in the debates on fees and counterparty risk.

Walsh says the way people use passives varies considerably: 'They may buy passive as a core holding - for the FTSE 100, for example - and then stockpick around that. Alternatively, they may want exposure to India, say, on a macro level but not know much about Indian companies, so they choose a passive fund.'

The main role of passives for many is to take on exposure to the largest stocks in an individual market. Oliver says: 'Many active funds are weighted to mid and small caps. Usually investors looking for exposure to larger-cap UK stocks are better off with a passive fund.'

Investors often use passives to get exposure to the US market, which has proved difficult for active managers to beat over the long term.

Gilts is another area where the use of passive funds is increasingly popular. Haynes points out that with a 10-year gilt currently generating an income of just 1.5 per cent, the effect of fees has greater impact on this investment, so gaining exposure at the lowest possible cost is important.

Other passive bond funds have yet to gain significant traction. Bond indices tend to place the highest weighting on those issuers with the highest debt burden, and that has not proved appealing.

In general, most advisers use passives for mainstream markets only. The use of currency ETFs or short ETFs has proved to be a game strictly for specialist investors. The 48 per cent loss on the Boost WTI Oil 3x Leverage Daily ETP since the start of the year highlights the perils of this type of passive investment.

Passives are no longer exclusively no-frills, but allow portfolios to be shaped in different ways. Investors should guard against believing they are simple. They have an increasingly important role to play, but they need to be selected as carefully as an active fund.

If you want to invest in an ETF please consider Interactive Investor, our sister site and award winning brokerage.


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