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5 Questions Worth Asking Your Passive Fund

With more money flowing into passive funds each year, investors need to understand what makes some passive funds better than others

Adam Zoll 17 June, 2015 | 9:21AM

All this week we are running a Guide to Active and Passive Investing to help you, the investor, make smart choices for your portfolio.

Passive funds are not all the same, even those that track the same index. While differences among passive funds may not be as stark as those among actively managed funds passive-fund investors still need to understand what makes some passive funds better than others. And with more money flowing into passive funds each year these distinctions apply to more investors than ever before.

Whether your portfolio is made up entirely of passive funds or just a proportion, the following questions can help you determine whether you've chosen wisely.

Question 1: Is there a Cheaper Option?

Among the most compelling reasons for choosing passive funds over actively managed funds is that they tend to be cheaper – much cheaper. You can pick up an exchange traded fund investing in the FTSE 100 for as little as 0.07% a year. Although you shouldn't choose a passive fund based on price alone, it is one of the most important factors. And with passive-fund providers engaged in a long-term price war over who can offer the lowest expense ratios, these are great times to be an passive-fund investor.

How you can tell: Compare ongoing charges using Morningstar’s Rank Funds tool.

Question 2: Tracker fund or ETF?

Exchange-traded funds, or ETFs, have become an increasingly popular way to invest in an index. ETFs often have an edge in terms of expense ratio over comparable traditional mutual funds and can be more tax-efficient because of the way they handle redemptions.

Plus, they allow investors to trade shares while the market is open rather than waiting until after it closes to make transactions. Yet, there are still times when owning a tracker fund makes more sense than owning a comparable index ETF, such as for those who are investing over time rather than in one lump sum as trading charges for ETFs on platforms can add up.

How you can tell: Exchange-traded funds have the acronym "ETF" included in the name. 

Question 3: What Index Does it Track?

Don't assume that passive funds in the same category track the same index. For example, many funds track the S&P 500, but some providers also offer ETFs that tracks the 750 largest U.S. stocks, giving it a slightly larger exposure to mid-cap stocks, even though it and the S&P 500 funds all land in the large-blend category.

Likewise, many funds track MSCI indexes, but Vanguard's foreign-equity funds track FTSE indexes. One key difference: FTSE counts South Korea as a developed market while MSCI counts it as an emerging market. 

How you can tell: Read the passive fund's prospectus closely to find out what index it tracks, or read the Fund Analyst Report. It's also a good idea to look at the fund's portfolio, under the Portfolio tab, to check out allocation, sector, and regional weightings.

Question 4: How Well Does the Fund Do its Job?

Of course, a passive fund's job is relatively straightforward: track an index as closely as possible. Yet, some do this better than others. So-called "tracking error" refers to gaps in the performance of a passive fund relative to its benchmark.

Because passive funds cost money to run, some tracking error naturally results from subtracting these expenses from the fund's performance. Yet, some funds find ways to limit this error – for example, by loaning out securities from their portfolios in order to make money to help offset expenses.

Another way passive funds can limit tracking error is by limiting their use of sampling, a method used by some passive funds to approximate the performance of hard-to-buy securities – such as the stocks of very small companies – rather than owning each of those securities individually. These ETFs are called “synthetically backed”.

How you can tell: Check the fund's performance relative to the benchmark, and relative to its competitors that track the same index. If your fund's performance tends to vary more widely than its competitors', this means that tracking error is a problem, even though the fund could end up performing better than the competition and even the index because of it.

Question 5: What Role Does the Fund Play in Your Portfolio?

As with active funds, a passive fund should fill a specific need in your portfolio. The good news here is that, unlike with active funds, performance should be rather predictable; you can expect close to the index's return no matter what happens.

However, just because you own a passive fund doesn't necessarily mean you are well diversified. If your portfolio consists of only equity passive funds, you may be neglecting bonds which could provide diversification and stability of returns.

How you can tell: Use Morningstar's portfolio X-Ray tools to make sure your overall allocation meets your needs.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Adam Zoll  is an assistant site editor with Morningstar.com, the sister site of Morningstar.co.uk.

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