Passive investment: which are better - index trackers or ETFs?
When it comes to gaining exposure to a wide range of shares, there are two main types of stock market investment: ‘passive’ and ‘active’.
There are significant differences between the two, but most investors will be concerned with key points such as performance and costs.
Traditionally, investing in shares meant paying a professional manager to actively make trading decisions on your behalf based on their skill and judgment, or making such decisions yourself.
In recent years, however, the notion of investing passively, where trading decisions are determined by what is happening in a stock market index, has grown in popularity.
Proponents say passive investing can deliver superior performance, at lower cost, than many actively-managed alternatives.
Here’s a closer look at the world of passive investing, including the most common ways for retail investors - the likes of you and me - to get involved.
Note that stock market investing involves risk and is not suitable for everyone. Before you consider investing, it’s important to work out your financial goals.
Ideally, build up a ‘rainy day’ cash fund equal to at least three months of your usual outgoings before taking the investment plunge. The value of investments can fall as well as rise, and your capital is at risk.
What is passive investing?
Passive investments, in all their guises, are underpinned by a simple aim. The challenge is to ‘track’ or replicate the return achieved by a chosen stock market index (or other investing benchmark). Computers are used to build and maintain a stock portfolio that copies the performance of the target index.
This might mean reproducing the performance of the FT-SE 100, the UK’s premier index of leading company shares, or the S&P 500 index in the US.
As noted, active management involves investment professionals striving to outperform a particular stock index or benchmark using a combination of analysis and experience – which tends to lead to higher costs for the customer.
Indices aren’t confined to stocks and shares. It’s possible to track the performance of all manner of asset classes and commodities, including commercial property and precious metals such as gold.
How do I invest passively?
When it comes to investing passively, retail investors tend to rely on two main products: index tracker funds and exchange-traded funds (ETFs).
According to statistics provider Morningstar, there was significant momentum behind the passive investment sector during 2021, when it accounted for about a fifth of the £8.5 trillion European investment funds market.
This represented an increase of nearly 10% on the previous year and compared with growth of around 2% achieved by actively managed investments over the same period.
Why invest passively?
The move to passives is not altogether surprising when you realise that only a minority of active managers are able consistently to generate a winning record.
According to analysts S&P Global, over the past 15 years nearly 90% of actively managed funds have underperformed their benchmarks. Investing platform AJ Bell says only a third (34%) of actively managed, shares-based funds managed to beat their passive alternatives in 2021.
Stock market indices contain dozens, hundreds, or even thousands of companies, meaning a passive investment is by nature diverse, avoiding any risk of placing too many eggs in too small a basket. This route is easier than actively taking out numerous individual shareholdings to achieve the same effect.
What is an index tracker fund?
Index trackers are a type of ‘collective’ investment. They pool the contributions of thousands of investors into one investing pot.
Some index trackers work by buying all the stocks in a particular index, with the holdings ‘weighted’ to reflect variations in the sizes of the individual companies concerned. This form of index tracking is referred to as ‘full replication’.
Other index fund managers shun full replication in preference for a process known as ‘optimised sampling’.
In this method, the profile of a particular index is recreated, but without the manager necessarily buying and owning all the underlying stocks that are contained within it.
What is an exchange-traded fund?
ETFs differ from index trackers in that they consist instead of ‘baskets’ of shares available to be bought and sold on a stock exchange throughout the trading day, at the current market price.
This contrasts with index funds, where the fund can only be bought for the price established at the end of a particular trading day.
So-called ‘physical’ ETFs hold the assets linked with an index and, as with index trackers, either replicate the index in full or rely on sampling.
Meanwhile, ‘swap-based’, or ‘synthetic’, ETFs use financial instruments known as derivatives to track an index. In this scenario, an ETF provides a basket of securities as collateral to a financial institution (such as an investment bank) in return for a ‘swap’ contract.
The ‘swap’ is a guarantee by the institution to pay out the return of the required index, in exchange for the performance of the collateral. An ETF provider’s website should tell you whether it offers physical or swap-based products.
Nowadays, almost all new passive investment product launches are ETFs.
Last year, the US was one of the first countries in the world to give the regulatory green light to cryptocurrency ETFs. These provide investors with the opportunity of gaining exposure to crypto assets, without having to store the coins themselves.
At time of writing (August 2022), crypto ETFs are not available via the London stock exchange.
How much do passives cost?
Passive investments tend to be cheaper than their actively managed counterparts.
Take an index tracking fund, for example. The fund ought to cost less to administer overall than it would if it employed a team of active managers and their associated support departments, including researchers and analysts.
However, you’ll still need to pay an annual fee to cover the administrative costs.
The average expense ratio of passively managed funds – in other words, the amount investors are charged – stood at around 0.006% in 2020, according to the Investment Company Institute.
This compared with a figure of more than ten times that amount (0.71%) for actively-managed US equity funds.
Applying these figures, investing £10,000 in a passive and an active fund would cost £6 and £71 respectively.
Additional charges, such as those connected with administration and dealing, may also apply depending on how a fund is bought, such as through an investing platform or trading app, or via a financial adviser.
Should I invest in index trackers or ETFs?
Launched in the 1970s, index funds have the longer track record. On balance, they are probably the easier version of passive investing of the pair to understand.
In contrast, ETFs came into being in the early 1990s. In recent years, it is these products which have attracted most of the marketing hype.
It’s important to bear in mind that not all ETFs work in the same way and some products track eclectic and off-the-beaten track markets.
With their shares-type characteristics, it’s also worth noting that ETFs have the potential to encourage investors to trade more frequently, which could ultimately result in higher costs and reduced returns.
According to ETF sponsor and asset manager WisdomTree, ETFs are more popular among younger investors. Recent research carried out by the firm found that more than a third of UK investors aged between 18 and 34 held ETFs, while the figure dropped to just 5% of investors aged 55 or older.
When all is said and done, however, whether you decide to invest in index trackers or ETFs is probably less important than the fact that you’re choosing to invest in passives in the first place.
Both offer lower fees than active investments for equal, if not superior, long-term performance coupled with plenty of portfolio diversification.
Investing in index trackers or ETFs via a stocks and shares individual savings account shelters any returns your investments make from three key areas of tax: income tax; dividend tax and capital gains tax.
