What you need to know about investing in funds

We've already told you that you'll be better off with passive' funds rather than active' funds.

Passive funds give you the same performance as the market. Active funds try to beat it, but usually fail, partly because their fees are too high.

So let's have a look at the ones you want - passive funds - in a bit more detail.

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First off, there are two main types of passive funds. There are index-tracking funds, also known as trackers. And there are exchange-traded funds (ETFs).

Here's how they work.

How tracker funds work

Tracker funds are not listed on the stock exchange. Like unit trusts, you can buy them direct from the fund provider, but it's usually cheaper to buy them from a fund supermarket' (such as Fidelity's FundsNetwork, or Hargreaves Lansdown)

So how do they work? Well, let's take a FTSE100 tracker.

A few examples of FTSE100 tracking funds (as of August 2012) are: the HSBC FTSE100 Index Tracker, the Liontrust Top 100 Fund and the Legal & General UK 100 Index.

The point of a fund like this is to copy the performance of the FTSE100 as accurately as possible. So one option is to buy every share in the index, and reconstruct it that way.

Say Vodafone accounts for 5.5% of the value of the FTSE100. The fund will put 5.5% of its money into Vodafone. So if the fund has £1m to invest, it will buy £55,000 worth of Vodafone shares. This approach is known as 'full replication'.

This isn't the only way to do it. Buying 100 stocks from the FTSE100 is quite easy and practical. But when it comes to a much larger index such as the FTSE All-Share, which has more than 600 stocks, then this approach isn't so good. Since the stocks are ranked by size, by the time you get to the 600th stock on the list, that stock is going to make up a tiny proportion of the overall index. And the impact of any move in that stock is so small as to be almost irrelevant.

So in this case, the tracker fund will buy a representative sample of the stocks in the market. Let's take an example. Oil and gas producers account for about 17% of the All-Share Index (as of August 2012). So if the tracker has £1m to invest, the tracker manager will put £170,000 into oil and gas stocks. But he might not buy every single stock in the sector, just the biggest ones. This approach is known as 'partial replication'.

Without wanting to overload you with detail, there is one further way that tracker funds are put together. This is called 'synthetic replication'. It sounds a bit creepy, like something out of a scary sci-fi film. But what it means is that these funds use derivatives contracts to match the performance of an index. That sounds really complicated, but in practice, it just means the fund provider pays an investment bank to give them the same return as the index.

This type of replication does introduce an extra layer of risk 'counterparty risk'. This means that the fund is reliant on the investment bank to deliver it the return on the index.

If the investment bank was to go bust, it wouldn't hold up its end of the deal. So investors in the fund could potentially get less money back than they expected. We'll talk about this in a future article, but for now it's just something to be aware of.

When it comes to buying a tracker fund, you can do this in a number of ways: through a fund manager directly, through a broker, or even through your bank.

And you don't have to put in a lump sum all in one go. Most providers should offer you the option of making regular or monthly investments for little or no cost. And you generally won't have to pay any upfront costs either, although it does depend on the provider.

Now let's have a look at how the other type of passive fund works: ETFs.

How exchange-traded funds (ETFs) work

Exchange-traded funds (ETFs) use similar tracking methods to tracker funds, from "full replication" to "synthetic". The main difference between ETFs and tracker funds is that ETFs are listed on the stock exchange.

Examples of popular ETFs are: the iShares FTSE 100 (LSE: ISF), which tracks the FTSE100 index; the HSBC S&P 500 ETF (LSE: HSPD), which tracks the S&P 500 index in the US, and ETFS Physical Gold (LSE: PHAU), which tracks the gold price.

Since ETFs are listed on the stock exchange, you buy and sell them through a stockbroker just as you would with shares in a company. This means there will be a difference between the buying and the selling price of the ETF - known as the bid-offer spread. You will also have to pay commission to your broker.

In the past, these costs meant that ETFs used to be quite expensive for those making regular as opposed to lump-sum - investments. Investing £100 per month with a £10 online dealing charge meant that 10% of your investment had been eaten up straight away.

Thankfully, more brokers include ETFs in their regular investment services' where you can invest monthly at a rate of as little as £1.50 per trade. So if you are going to invest regularly in an ETF, make sure you set up one of these regular investment accounts.

The main reason to buy passive funds: low costs

The point of buying tracker funds is that they are cheaper than actively-managed funds. The annual fee on an actively-managed fund will usually be upwards of 1.5%. For a tracker, fees of less than 0.5% are common. As a rule of thumb, the more exotic the market, the higher the fee will go. But if you're being charged 1% or more, look elsewhere.

Two things to watch out for

There's another thing to watch out for: tracking error. A tracker or ETF can't be expected to match its index with absolute precision. Because you have to pay an annual fee, you'd expect it to underperform the index by at least that much.

But there are other costs involved too. For example, trading costs and taxes will also add to the costs of running a passive fund. And depending on the tracking method used, there may be other costs that aren't included in the annual fee.

All this means that some trackers and ETFs will follow their index better than others. So before you buy, compare the past performance of the fund (which you should be able to get off the fund factsheet available from the provider, or from a website such as www.trustnet.com) to the performance of its index.

You're looking for the one that shows the least divergence from the index in other words, the one that tracks its market best. After all, there's no point in paying a low annual charge if you end up with a fund that then loses you more money than it saves due to tracking error.

Remember: always make sure you know what you're buying!

Passive funds look straightforward. And most of the time they are, which is one of the reasons why we like them. But as we hope we've hammered home by now, do make sure that you know what you're buying.

ETFs in particular are very useful, but they can contain potential pitfalls for the unwary. More complex ETFs offer ways to profit when markets go down, or profit from more exotic asset classes, such as soft commodities or currencies.

There's nothing wrong with these products as such, but you really have to know what you're doing to invest in them. We'll run through the things you should watch out for in the next article.

This article is taken from our beginners' guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here .