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Passive Index Funds

So, what are they exactly?

A passive index fund allows investors to track the performance of a pool of underlying assets at low cost.

Now, it may well be that only some or perhaps none of the words passive, index or fund make much sense. So let’s look at each part to help clarify exactly what they do day to day for investors.

First off, what does “passive” mean? Broadly there are two type of investment management, one is “passive” and the other “active”. Passive management gives investors access to specific parts of the market, typically based on a set of rules that the investor is happy with. Because it is rules driven, it strips out human emotion, there is clarity on whether or not company A or B should be included and for that the investor tends to pay lower fees than for their “active” counterpart.

With an “active” fund you are backing and so paying for the skill of the active manager and her or his team of analysts to pick companies that together may (or may not) outperform their target (benchmark) year on year. Unfortunately the research is not positive on managers consistently beating their benchmarks.

What is an “index”?

In the news you are likely to have seen the FTSE 100 mentioned when equity markets are being talked about. This is often taken as an indicator for how the UK equity market is performing as this particular index captures the performance of the largest 100 (or so) companies listed on the London Stock Exchange, so the likes of Vodafone or HSBC and so on. The S&P 500 is from over in the US, with exposure to, you’ve guessed it, the largest 500 US companies.

But an index does not have to be based just on the size of the company (although many are), the rules could be broader and cover a range of countries, asset classes, industries or a specific type of investing such as only selecting companies that meet pre-set environmental, social or governance criteria, e.g. no weapons or alcohol.

Lastly what is a fund?

A fund allows you to spread your investment risk nice and speedily across assets. In this case investing in the index, rather than having to go out yourself to buy each and every underlying holding in the right weightings (which may be a fair amount of work and result in lots of trading fees).

It is also (less excitingly but importantly) the legal structure for your investment, to make sure that is the right framework for you as a UK based investor. In different countries there are different tax regimes and so it is important to have the right fund type depending on where you are. So not exciting but could be annoying if you get the wrong one.

What are the pros?

A key advantage of index funds is that they are a low cost option, charging just a fraction of a percentage point each year (0.05% to 0.25% being the general range of the ones we use, some more specialist ones may charge slightly more), while many active funds, for instance, may charge between 1-2% per annum.

Passive funds are cheaper because they aren’t trying to guess individual winners in the stock or bond markets but instead are designed to track an entire group of investments. That means fund managers don’t need hire expensive analysts to try and work out which companies might do well.

Scared about losing out on dividend payments? Don’t worry, passive funds collect dividends from the various companies and pass the money onto you (that’s what the dividend yield shows), or as in many of the fund we use, immediately reinvest them to keep you money growing (compound growth makes a big, big difference over time).

Is there anything to be careful about?

Index funds are still funds and still have fees. While these fees are much lower than those of active funds, you could technically avoid those fees too by going out and buying all the individual stocks or bonds the fund invests in. It would be time-consuming, but it would cost less (though you’d still have to pay dealing fees, that can mount up).

As with all diversified funds, the chances for big gains are smaller than if you’re buying an individual stock (as are the chances of losing your shirt).

And finally, buying and selling units usually costs a small commission fee—the same as buying or selling shares of a stock—the size of which depends on the broker. At Wealthsimple, we take care of this for you.