Passive / tracker funds - what are they and why might you choose them?

Thursday, 26 July 2018

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Investment management using passive funds

Tracker funds and exchange-traded funds (ETFs) are investments that aim to mirror the performance of a market index. A market index follows the overall performance of a selection of investments. The FTSE 100 is an example of a market index – it includes the 100 companies with the largest value on the London Stock Exchange.

As such, tracker funds differ from "active" funds, where you pay a fund manager an extra fee to try and beat the index, not just match it.

INDEX PERFORMANCE
Tracker/passive funds are financial instruments you buy from a fund company that aim to track the performance of an index. ETFs do the same but are listed on a stock exchange and can be bought and sold like shares. Trackers and ETFs are available to track many indices. Trackers and ETFs work either by physically buying a basket of investments in the index they’re tracking or by using more complicated investments to mimic the movement in the index.

LOWER CHARGES
Investment decisions are made automatically according to the fund’s rules. This passive trading makes index trackers cheaper to run than actively managed funds, so many have lower charges. With index trackers, you own a share of the overall portfolio – if the value of the assets (shares, etc.) in the fund rises, the value of your share will rise. If the value of the assets falls, then so will the value of your share.

ASSET CLASS
Index trackers are a way to spread your risk within an asset class without having to spend a lot of money. For example, if you want to invest in UK equities then buying a FTSE All Share Tracker Fund will give you exposure to more than 1,000 companies, at very little cost. The tracked index can go down as well as up, and you may get back less than you invested. Because of charges, a tracker will usually underperform the index somewhat, and over a long period that underperformance could be more noticeable.

GOOD FIT
Before investing, make sure you understand whether the index tracker is physical or synthetic and whether it is a good fit for your goals and risk appetite. A synthetic tracker is an investment that mimics the behaviour of an index through the use of derivatives such as a swap. Synthetic tracker funds and ETFs rely on a counterparty underwriting the risk, and so carry the risk of counterparty failure (for example, Lehman Brothers in 2008). There are various controls which aim to reduce this risk, but we never recommend using any product which uses derivatives to match a market index. That's why we tend to use tracker funds rather than ETFs.

DIVIDEND ALLOWANCE
The current tax-free Dividend Allowance is £2,000 (2018/19). Dividends received by pension funds or received on shares within an Individual Savings Account (ISA) will remain tax-efficient and won’t impact your dividend allowance. There are three dividend tax bands which currently apply to all dividend income in excess of £2,000 per year:

  • 7.5% (for basic-rate taxpayers)
  • 32.5% (for higher-rate taxpayers)
  • 38.1% (for additional-rate taxpayers)

If your fund has invested in corporate bonds, gilts or cash, it should pay interest, and that interest will be treated differently to dividend income. You are entitled to a personal savings allowance (2018/19). This means you don’t pay tax on the first £1,000 (£500 if you’re a higher-rate taxpayer) you earn from interest from:

  • Bank accounts
  • Building societies
  • Savings accounts
  • Corporate bonds
  • Credit union accounts
  • Government bonds and gilts

Any profit you make when selling your shares or units counts towards your Capital Gains Tax annual exempt amount. Losses can be offset against other gains in the same tax year or carried forward to future years.

OUR APPROACH

We use tracker funds to give our clients exposure to individual asset classes (e.g. US equities) at low cost. This not only saves money but also avoids the risk that an "active" manager will make a serious mistake in their stock selection, costing our clients' money. However, we do sometimes use "active" funds where there is no passive alternative, such as when we want to own "physical" property funds (i.e. funds that buy office buildings or retail units). There can also sometimes be an argument for "active" funds in the bond market, and the emerging equity markets, where stockmarket indices can be less efficient.

For more information, just get in touch.

Chartered Financial Planners. FCA Regulated (FCA no. 603653)