Passive investors have never had it so good. Costs are falling at the same time as their opportunity to tap into markets increases.
Yet with that extra choice comes a bewildering array of options. It’s not just about tracking a market anymore, smart beta strategies which combine passive approaches with active allocation and ready-made passive portfolios are also being snapped up by investors.
So what are your options and what does a good tracker look like? We look at what’s on offer.
Track the market: An index fund won’t beat the market, but there are good ways to follow its performance
The rise of the tracker
An index tracker or exchange traded fund can provide a low cost way to invest and spread your risk.
The aim of both is to simply follow a set index or basket of investments, with no fund manager actively choosing when to buy or sell to try to beat the market.
There are differences between the two.
An index tracker is an open-ended fund that you can invest in the same way you would a normal investment fund and will always reflect the value of the assets it holds.
An exchange traded fund, commonly known as an ETF, is traded on the stock market and bought or sold in the same way that you would buy shares. Most will simply reflect the value of the assets they hold but if there is a big swing in demand, the price of a share in an ETF could be pushed above or below the value of what it owns.
Tracker investors will never beat the market.
Passive funds such as index trackers or ETFs have lower fees, but investors are banking on markets doing well over time. If a market drops, then so will your investment.
Passive funds attempt to track the performance of an index and your returns effectively reflect the market’s performance, while active managers try to beat it.
Investors in active funds tend to pay more for a fund manager’s expertise but the problem is that spotting which ones will outperform in advance is notoriously difficult.
There is always the risk of the portfolio underperforming the market and losing money, as well as returns being eaten up by fees.
Smart beta trackers
Muddying the waters, a new breed of passive investments has arrived – dubbed smart beta. These are funds, typically ETFs invested in shares, that use a strategy to pick out assets that should do better than the wider market. They then follow a basket of these and rebalance regularly.
An example of this is an ETF that rather than tracking the entire FTSE 100 index chooses instead to pick out the top dividend-paying shares in it and follows a basket of those instead.
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Should you track or not?
At This is Money we favour a balanced approach between both active and passive investing depending on your own personal outlook and the costs and markets you are trying to access.
We would recommend reading up on the active vs passive debate beyond this article and thinking about what best suits your views. There are also some markets where it can make more sense to track, such as large well-researched ones like the US S&P 500.
Jason Hollands, of Tilney Bestinvest, says trackers can be particularly effective in markets such as the US where active managers are struggling to add value.
As with any investment, you also have to consider how you choose your tracker as you need to ensure you are diversifying so if one market or region falls, the rest of your investment won’t suffer.
We run through some of your passive options below.
The classic trackers and ETFs
Most investing platforms will let you put money into trackers or ETFs. You can read research and guides online and select your own. Pay attention to costs, cheaper investing is among the chief reasons for choosing a tracker, so don’t overpay.
You will also need to consider the total cost of investing, which includes dealing fees and any annual charges your platform has.
Some DIY investing platforms will let you buy and sell funds for free, others charge. ETFs incur share-dealing costs which vary across platforms.
You can now track the FTSE 100 for as little as 0.07 per cent using the iShares FTSE 100 ETF.
Legal & General has a FTSE 100 tracker at 0.10 per cent or 0.06 per cent through Hargreaves Lansdown, or the Blackrock 100 UK Equity Fund charges 0.07 per cent.
Alternatively, Fidelity offers a FTSE All-Share tracker at 0.08 per cent, or 0.06 per cent if purchased on its platform.
For the US, Jason Hollands recommends the Vanguard S&P 500 UCITS ETF which has an ongoing charge of 0.07 per cent.
Alternatively, PowerShares FTSE RAFI US 1000 UCITS ETF offers a different approach to a traditional size weighted tracker and instead holdings the 1,000 largest US companies but ranks them according to earnings, dividends and balance sheet strength. This fund has an ongoing charge of 0.39 per cent.
For European exposure, Mr Hollands suggests the HSBC European Index fund, charging 0.10 per cent.
Those wanting to get into Japan could consider the Fidelity Index Japan fund from Fidelity, which has a 0.12 per cent charge, according to Mr Hollands.
For emerging markets exposure, you could also get a Fidelity Index Emerging Markets tracker at 0.23 per cent or 0.21 per cent if purchased through Fidelity, or BlackRock’s Emerging Markets Equity Tracker is priced at 0.25 per cent
The cheap do-it-all trackers
Diversification often gets referred to as investing’s only free lunch. It typically requires quite a bit of work though.
Rather than research markets and find the best funds to diversify with, you could trust a provider to do it for you.
They will sort the asset allocation for you, all you usually have to do is choose a risk profile and strategy.
You will pay more than a single index fund, but you will be accessing a much broader spread of investments at the same time.
Vanguard offers a range of LifeStrategy portfolios that put your money into a range of index funds and bonds from around the world.
These can be 100 per shares from around the world, or step down in a mixture of shares and bonds from 80 per cent shares / 20 per cent bonds to 20 per cent shares / 80 per cent bonds. The ongoing charges figure is 0.24 per cent
HSBC has its World Index Portfolios. These fall into three categories Cautious, Balanced and Dynamic and again blend shares and bonds, but they also add some other stuff.
The portfolios carry a heftier ongoing charge than Vanguard though, starting at 0.17 per cent for cautious, 0.19 per cent for balanced and 0.19 per cent for the dynamic portfolio.
Smart beta – the trackers that try to beat the market
The risk with any passive fund is that if markets fall, so will your investment. Meanwhile, when they rise you don’t get to pick the winners that let active managers outperform.
Diversification is one way around this, but there is now a middle ground called smart beta.
Smart beta combines active decision making with passive investing.
A smart beta fund, usually an ETF, will follow a particular index but its allocation can be adjusted based on certain parameters such as risk, sector performance or momentum.
Because there is an element of human intervention, you will typically pay more than the cost of a traditional passive fund but slightly less than an active manager would charge.
For example, Barclays and investment managers Ossiam teamed up to launch a value-hunting ETF that uses Professor Robert Shiller’s famous CAPE ratio, also known as Shiller PE.
The CAPE ratio, or cyclically adjusted price-to-earnings ratio, was devised by Professor Shiller in 1981.
It measures how expensive a market or share is over time.
CAPE divides current market price by an average of annual earnings across a number of years, typically ten. The theory is that is not skewed by whether the economy is doing well or badly – so it smooths out economic cycles – and so is useful for valuation comparisons over time.
The Ossiam ETF, which has a charge of 0.65 per cent, tracks the Shiller Barclays CAPE® Sector Europe Index.
Professor Shiller has worked with Barclays to devise special indices looking at European markets using the strategy.
They looked at the ten MSCI Europe sectors going back to 1998 and determined index prices and earnings for them.
Using the CAPE ratio, the strategy identifies the five most undervalued sectors. It then eliminates the one with the least momentum over a year to come up with four sectors in total.
It says this means it identifies the four cheapest sectors with the the best momentum and the ETF invests to follow an index based on these. It is rebalanced each month.
The ETF was only launched in February 2015, but back testing calculations from Barclays show the CAPE-based index would have returned 17.45 per cent a year compared with 12.26 per cent from the MSCI Europe Index between December 2008 and December 2014.
However, in the year up to February 2016 it has lost 5.26 per cent, just below the MSCI Europe Index which is down 5.37 per cent. This shows the risk of investing in trackers and ETFs when markets fall and the importance of diversification and thinking long term.
You would need to invest in more than one smart beta fund to achieve diversification, but you don’t necessarily have to do all the work yourself.
State Street Global Advisors approaches smart beta a different way.
The provider offers an S&P UK High Yield Dividend Aristocrats Index ETF that tracks the performance of the 30 highest dividend-yielding UK companies within the S&P Europe Broad Market Index.
The top 30 are identified from companies that have increased or paid stable dividends consistently over the past decade.
The ETF has an ongoing charge of 0.30 per cent and has returned 16.04 per cent over five years, outperforming the Global ETF Equity – UK index which returned 5.72 per cent.
Investing platforms that build a tracker portfolio
There are also investing platforms that will build a portfolio for you.
For example, Nutmeg builds a portfolio based on your risk-appetite that invests purely in ETFs.
Its charges start at 0.95 per cent for a minimum £1,000 investment and get lower the more you invest.
Shaun Port, chief investment officer for Nutmeg, says: ‘We regularly make changes and adjust the asset allocation depending on what is happening in global markets. We also rebalance all portfolios on a monthly basis. We find that investing in ETFs offers us great flexibility in trading and enables us to keep costs low for our customers.’