The popularity of passive investing has reshaped the asset management industry as index funds have attracted a raft of investors with the promise of much lower costs than actively managed alternatives.
These investments simply aim to replicate the performance of a certain index, such as the S&P 500 or the FTSE 100, as opposed to actively managed funds, which are run by managers who try to pick and choose stocks in order to beat an underlying index.
Last year more money flowed into passive funds than into active funds that try to pick the best stocks as investors try to avoid hefty management fees for similar returns.
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Passive fund popularity
The first index fund (also known as passive funds or trackers) that was available to ordinary investors was the First Index Investment Trust, which launched at the very end of 1975 (it’s still going, but now it’s called the Vanguard 500 Index Fund).
Almost four decades later, assets in passive tracker funds now exceed assets in actively managed funds. Around 40% of the total net assets managed by funds in America are in passive vehicles, according to the Investment Company Institute, an industry group.
Over the years investors have flocked to passive trackers as expensive active funds have proven themselves to be poor value for money. High management fees have eaten away at returns, and most managers have failed to outperform their benchmarks, leading many investors to question why they’re paying for underperformance.
Management fees in a conventional investment fund are often around 1 to 2%, a hefty figure when we consider that some index funds charge as little as 0.06%.
There are also signs that the actively managed exchange-traded funds (ETFs) are faring better than actively managed mutual funds.
The discrepancy in fund flows, which speaks to the speed at which ETFs are eroding mutual funds’ market dominance, has accelerated from $950bn in 2021 to $1.5trn this year, according to statistics gathered by Bloomberg Intelligence.
“Bonds having their first major bear market in over 40 years has resulted in a colossal industry-altering move from mutual funds to ETFs,” Todd Sohn at Strategas Securities told Bloomberg News.
The ETF strategist added, “It’s been a development really two years in the making, going back to the Fed buying fixed-income ETFs in 2020, and then the rise of inflation and a tighter Fed resulting in a major bear market for bonds.”
Blend of active and passive
Chris Gooch, head of ETF and index sales, EMEA, at Citi notes that active ETFs have played a huge role in that move. “There has been a general trend away from mutual funds towards equity ETFs more broadly, and active ETFs have very much participated in that move”.
According to Bloomberg Intelligence data, ETFs have been growing across the board, bringing in close to $588bn so far this year and on track for their second-best ever annual harvest.
Other market watchers attribute the stronger performance in active ETFs to a change in an ETF rule. The ETF rule was introduced in 2019 by the US regulator, the Securities and Exchange Commission and was introduced to make the market more competitive and make the process of bringing ETFs to the market more efficient.
Another factor that played a part was the US regulator approved non-transparent and semi-transparent structures.
The change meant active managers no longer had to disclose or report the fund’s daily composition, meaning some active managers could retain their “secret sauce”.
However, passive funds are still largely the favourite go-to investment of robo-advisers. These investment platforms use a portfolio of funds to meet investors’ goals while trying to keep costs as low as possible.
That said, while passive low cost index funds do have some attractive qualities, the nature of these products mean they cannot outperform the wider market. They’re only designed to track the market, and therefore, cannot outperform it.
Critics of passive funds also say that they lack flexibility. Even if index fund managers note a deterioration in the performance of the benchmark, they usually cannot simply trim the number of shares they own.
There are usually fewer moonshot opportunities under passive funds. This is because in mirroring the market, there is likely to be fewer opportunities to earn a significant windfall.
While there are usually fewer risks involved with passive investing, reward is also more limited compared to active funds. As such, some investors prefer to take their chances with active managers and are ready to weather market volatility (not all active managers have underperformed the market over the long term).
How to look for low cost index funds
So what should you look out for when choosing the best index funds and ETFs? There are several factors to be aware of.
Low costs are key, of course. But it’s also important to consider the tracking error (the difference between the performance of the index and the fund). Since the goal of the tracker is to match the performance, significant outperformance is just as much of a reason to worry as is significant underperformance, as it suggests problems with the way the fund is run. It can also indicate how fees will hit performance in the long run.
Every penny you pay in management fees is a penny that doesn’t compound over time. So investors should look for low cost index funds with the lowest possible total expense ratios (TERs) – the annual running costs for the fund. Some brokers, such as Hargreaves Lansdown, offer management fee discounts for investors who pick their preferred funds.
Listed or unlisted
Different types of funds are suitable for different types of investors. Many online stockbrokers have different charging structures for different funds. That means the best fund for you might depend on which is the cheapest and easiest to buy and sell. ETFs can be bought and sold when the market is open, while Oeics can take days to buy and sell as they need to create and redeem shares for investors.
Entry or exit fees
Some funds can charge large entry or exit fees. None of the funds on the list below charge entry fees, but there are some on the market that charge as much as 5% for new investors.
These fees can be a huge drag on returns in the long run, especially when other charges are added. This excludes trading commissions, which some brokers might charge when dealing funds (these fees can turn even the best-looking low cost index funds into expensive investments).
Here’s a selection (it’s far from an exhaustive list) of the cheapest passive tracker funds (Oeics and ETFs) on the market right now.
This list does not reflect all the fees and charges (as well as discounts) that might apply though different brokers.
|Index tracked||Fund||Expense ratio|
|UK Equities||Row 1 - Cell 1||Row 1 - Cell 2|
|FTSE 100||iShares 100 UK Equity Index Fund||0.06%|
|FTSE 250||Vanguard FTSE 250 UCITS ETF||0.10%|
|FTSE All-Share Index||Vanguard FTSE UK All Share Index Unit Trust||0.06%|
|MSCI United Kingdom Small Cap Index||iShares MSCI UK Small Cap UCITS ETF||0.58%|
|FTSE UK Equity Income Index||Vanguard FTSE UK Equity Income Index Fund||0.14%|
|Bonds||Row 7 - Cell 1||Row 7 - Cell 2|
|FTSE Actuaries UK Conventional Gilts All Stocks Index||Legal & General All Stocks Gilt Index Trust||0.15%|
|iBoxx £ Non-Gilts Overall TR Index||iShares Corporate Bond Index||0.11%|
|Bloomberg Global Aggregate Float Adjusted and Scaled Index||Vanguard Global Bond Index||0.15%|
|JP Morgan EMBI Global Diversified Index||L&G Emerging Markets Government Bond (USD) Index Fund||0.32%|
|Global||Row 12 - Cell 1||Row 12 - Cell 2|
|MSCI World Index||Fidelity Index World||0.12%|
|S&P 500||Vanguard S&P 500 UCITS ETF||0.07%|
|Solactive L&G Enhanced ESG Developed Markets Index NTR||Legal & General Future World ESG Developed Index Fund I GBP Inc||0.15%|
|MSCI Emerging Markets Index||L&G Emerging Markets Equity Index Fund||0.25%|
|FTSE Developed Europe ex UK Index||Vanguard FTSE Developed Europe ex-UK Equity Index Fund||0.12%|
|FTSE World Asia-Pacific ex-Japan Index||iShares Pacific ex Japan Equity Index||0.11%|
|FTSE Japan Index||iShares Japan Equity Index||0.08%|
|Row 20 - Cell 0|
|Mixed||Row 21 - Cell 1||Row 21 - Cell 2|
|N/A||Vanguard LifeStrategy 80% Equity Fund||0.22%|
|N/A||Vanguard LifeStrategy 40% Equity Fund||0.22%|
|N/A||Vanguard LifeStrategy 60% Equity Fund||0.22%|
These mixed funds are technically not tracker funds as they do not track an index. They target a certain allocation to equities and bonds with the overall ambition of achieving positive returns for investors with reduced volatility. They do this by having higher or lower allocations to bonds and other fixed-income securities.
These products could be ideal for investors who want to own a large, diversified portfolio of investments without having to manage the portfolio on a day-to-day basis themselves.
Pedro Gonçalves is a finance reporter with experience covering investment, banks, fintech and wealth management. He has previously worked for Yahoo Finance UK, Investment Week, and national news publications in Portugal.
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