Investing has transformed over the past several decades, and one of the key innovations driving this change has been the emergence of passive funds. Characterised by their low fees and simplicity, passive funds (including exchange-traded funds) provide investors with an effective way to gain diversified exposure to various asset classes and market themes. There are hundreds of tracker funds available to UK investors, so how exactly do you go about building a passive portfolio?

RISK, OBJECTIVES AND ASSET ALLOCATION

The first thing to think about is the amount of risk you want to take and what objectives you have for your investment. How much risk you wish to take will determine how much to invest in shares, and how much to invest in bonds.

An adventurous, younger investor might choose to invest 100% in stocks, whereas someone approaching retirement might feel more comfortable with a portfolio that is split 60% in favour of shares with 40% in bonds for some ballast to smooth out market volatility. You can then either populate your portfolio with individual stock and bond trackers, or you can simply buy a tracker fund which invests in both stocks and bonds.

Your objectives should also come into play and might determine whether a fully passive portfolio is right for you or not. If you’re simply after growth, then a portfolio of index trackers is pretty straightforward to pull together.

But if you have specific needs, like a regular income stream, or you wish to invest in specialist areas which are not well served by tracker funds, like smaller companies, then you might need to consider active funds instead. There’s no harm having a mix of active and passive funds in the same portfolio in any case.

REGIONAL EQUITY DIVERSIFICATION

This is the most difficult part of building a portfolio because there is no ‘right’ answer, unless you have a particularly reliable crystal ball which tells you which markets are going to perform best. There are a number of different approaches you can take to this conundrum.

The first is to simply allocate your money across the global stock market based on company and market size. This is effectively what a global tracker fund would do, so you could just buy one of these. The benefit of this approach is it’s really simple, rebalancing isn’t required as this automatically takes place, and your fund performance will roughly match up with the global stock market.

The downside of this approach is it will lead to a portfolio that’s heavily exposed to the US stock market, as that’s where the biggest companies are.

An alternative, slightly more active approach would be to invest a fifth of your portfolio in each of the major regional markets: the US, UK, Europe, Japan and emerging markets. This adds some balance in terms of where your risk and reward is coming from, and you can use it as a baseline for making active regional allocation decisions if you so wish, boosting exposure to one area you have confidence in at the expense of another you think is a bit of a dog’s dinner.

HOW TO PICK THE RIGHT INDEX

Once you’ve decided the overall shape of your portfolio in terms of asset classes and regions, it’s time to pick funds to fit into each of the slots. There are several things to look out for, but the top three are the index being tracked, the tracking difference, and charges. The index being tracked normally takes care of itself when picking plain vanilla index trackers, which will follow broad market indices. At the margins there may be some decisions to be made, in the UK whether to invest in a fund that tracks the FTSE 100 or one which follows the wider FTSE All Share, for example.

You might also have a bit more research to do if you are investing in more niche or thematic trackers, where the indices are less well known, in which case you should familiarise yourself with how the index is constructed so there are no nasty surprises along the way.

The tracking difference is the performance differential between the passive fund and the index it is tracking. You want this to be as small as possible, though bear in mind there will always be a bit of a wedge because of fund charges, and this will widen the longer the time period you look at. You can find the tracking difference by looking at performance on the fund’s factsheet, which should be set against the index.

LAST BUT NOT LEAST… CHARGES

Charges are always important, but perhaps particularly so with passive funds. If a tracker is doing its job correctly, it will underperform the index each year by the level of fees it levies. The cheapest UK tracker fund costs just 0.05% per year, while the most expensive charges more than 1%. Because there should be no difference in performance before charges, the latter is simply feathering the nest of the fund provider rather  than investors.

Over the last 10 years the most expensive fund has turned £10,000 into £16,336 after charges, but it would have been worth £17,999 in the cheaper tracker. Which one to choose is as close as you will get to a no-brainer.

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