why you should stuff your Isa with cheap passive funds

published 24 February 2017

170223-passive-funds-b — Tracking the market is cheap

Opening an Isa for your savings and investments makes a lot of sense.

It'll shield your savings from tax, and even the most affluent savers will find there's plenty of room to build up a decent nest egg over the long term.

But of course, opening an Isa is just the start.

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The tricky thing is knowing what to put in it.

And that's what I want to discuss over the next couple of days.

Forget the jargon let's just talk about how we go about investing

Today, I want to talk about passive funds, and why they should be among your first ports of call when considering what to put in your Isa.

I usually start these discussions off with a definition. But instead, I'm going to avoid the jargon and explain it in a way that I think makes more sense.

Let's say you want to invest in the stockmarket. You can buy stocks in Britain. You can buy stocks in the US. Or maybe Japan. Or maybe all of them.

How do you make that choice? Well, you might take a look at individual stocks yourself. That can be very interesting, and potentially very profitable (most of the 12 private investors interviewed in Free Capital, the book we're currently giving away to new MoneyWeek subscribers, made their millions from investing in individual stocks).

However, you have to have both the time and the inclination to develop your understanding of company accounts and the time and inclination to research them.

That's not everyone's cup of tea. Some people just want to be able to put together a "buy and forget" portfolio that they can save into over the long run. In short, they want to benefit from the fact that stock markets have generally delivered better returns than a bank account over the long term, without having to spend a lot of time trawling the market.

So you could buy some funds instead. Funds pool a lot of investors' money, and then invest it on their behalf. So how do you choose which fund you want to buy?

As a UK investor, your first port of call is likely to be the FTSE 100. it's Britain's big domestic market, the stocks are listed in sterling, and it's the obvious choice.

But you don't want to just tie up all your money in the UK. By investing some of it overseas, you can get access to different types of companies, and also you don't have all your eggs in the UK basket (the panic in the aftermath of the Brexit vote may have demonstrated the value of that).

So you might decide that you want to have a chunk of your money in Japanese stocks, and maybe some money in European stocks. You look at US stocks too the market is expensive right now, but you decide you should have at least a little bit of exposure there, seeing as it's the biggest economy in the world. And you fancy putting some money in emerging markets too they're cheap and they have the potential to grow more rapidly over time.

This process is known as "asset allocation". All it means is that you are deciding how much of your money should be invested in each asset. So maybe (and this is an example, not a recommendation) you want 30% in UK stocks, 20% in emerging markets, 20% in Japan, 20% in Europe, and 10% in the US. (You'd probably also want some money in cash and gold, and maybe a little in bonds and property, but let's ignore that for now.)

And so far, none of the decisions you've made have actually involved picking an individual fund to invest in.

Two choices an expensive punt or a cheap sure thing

So now you know. You want 30% of your money in UK stocks. Presumably you've made that decision because you think UK stocks are cheap (and therefore have the potential to make greater returns), or because you think that Brexit isn't going to be a disaster, or because you simply think it makes sense to have significant exposure to sterling assets in your portfolio because you're not keen to take currency risk.

Whatever the reason, you now have to ask how am I going to get that exposure?

Here are your two main options.

For a small annual fee, you can put your money into a fund that will give you pretty much the exact same return as the FTSE 100 or FTSE All Share makes over the coming years. You don't know what you'll make stockmarkets can go down as well as up, and they are unpredictable beasts but you do know that it will be very, very close to whatever the market makes.

Or, for a larger annual fee, you can put your money into a fund that will try to beat the FTSE 100 or FTSE All Share over the coming years. The problem is, there's no guarantee that it will. In fact, the odds are very much against it over the long run.

In other words, you can pay a small fee to track the market. Or you can pay a large fee to gamble on beating the market, but in the knowledge that there's a much better chance that over the long run you will underperform, rather than outperform.

Or, put differently yet again, you can get cheap exposure to a market that you (presumably, because you've chosen it) believe is going to make a decent return over the long run. Or you can take an expensive bet that's likely to go against you.

That's the "passive" versus "active" choice in a nutshell.

"Passive" describes the tracker funds. They're cheap because they simply track the underlying index. "Active" describes funds where a human manager who charges a big fee tries to pick stocks and so beat the underlying index. They don't normally manage it, because apart from anything else, they have to both beat the market and earn enough of a premium to offset their own fees, before the investor is up on the deal.

There's nothing "passive" about buying passive investments

Can you see why I don't like the terms "passive" and "active"? There's nothing "passive" about the process we just described. The investor has made active decisions about their own asset allocation all the way down the chain.

The decision on whether to choose an "active" or a "passive" fund is simply a decision on which vehicle is best for executing an investment strategy that's already been agreed upon. if anything, that's the hard part.

In other words, all investing is "active". All you're really deciding on at this point is whether you want to buy a "cheap" or an "expensive" fund.

Anyway, that's why I think the starting point for any investor should always be to consider the passive option a tracker fund or "exchange-traded fund" (ETF). We'll have a lot more about this including how to build a passive portfolio for your Isa in the MoneyWeek Isa special next week. Subscribe now so that you don't miss it.

Meanwhile, tomorrow I'm going to talk about the one type of active fund that we have a lot more time for the investment trust.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.