Cover all bases with passive funds

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The use of passive vehicles in investment portfolios is becoming more common as financial planners and advisers recognise the merit of this low-cost approach. And, while some will use a combination of actively and passively managed funds, others prefer to use passive wherever possible.

In many ways, the building of a passive portfolio requires an identical approach to that taken by advocates of active management. Advisers start out by assessing an investor's objectives and attitude to risk before putting together a diversified portfolio to meet their requirements.

"Investors should have exposure to four asset classes: cash, property, equities and fixed interest," Jason Witcombe, a chartered financial planner and director at Evolve, explains. "Cash is usually held separately in a savings account and most investors already have exposure to property through their home, so I'd look to build a portfolio covering equities and fixed interest, varying the proportions according to an individual's appetite for risk."

But, while the fundamentals are the same, there are some key differences between the passive and active approaches. For starters, because there's no need to worry about the diversification of fund management styles with passive funds, the number of funds required to construct a portfolio can be much lower than the number required with active funds.

John Lang, director of Tower Hill Associates, says he would recommend a light portfolio of just four or five passive funds for someone starting to invest. "This would give them sufficient diversification and would only deliver performance around 0.5% lower than a broader portfolio suited to a client with more money to invest," he explains.

Witcombe goes even lower. "If you're starting out, three funds are enough. You can cover all the bases with a UK equity fund, a global equity fund and a global fixed-interest fund," he says. As the value of the portfolio increases, the number of funds increases too. Many advisers say that a portfolio of between 10 and 12 funds is ideal for a more sophisticated passive portfolio, as this offers more asset class diversification.

Nick Crabbe, a certified financial planner and wealth manager at Manse Capital, uses three passive bond funds to give clients access to fixed-interest investments: Dimensional Global Short-Dated Bond, which invests in high-quality bonds with five years or less to maturity; Vanguard Global Bond Index, which invests in bonds that take longer to mature; and Legal & General Index Linked Gilt fund, which invests in UK government bonds.

Going passive does throw up some challenges. While it's easy to find suitable passive vehicles for most asset classes, advisers struggle with some, such as property and commodities, and often use active funds instead to gain exposure.

Some are able to use passive funds. For example, Lang uses an exchange traded fund, iShares FTSE EPRA/Nareit Developed Markets Property Yield, to gain exposure to the property market for his clients. Commodities can be more difficult to access. "There are ETFs that track commodities but they're tracking the future price rather than the spot price. This can cause confusion, so we prefer to use an active fund, JPMorgan Natural Resources, for commodity exposure," he says.

Another challenge is posed by the way the indices are made up. For example, Crabbe says you might invest in a fund tracking the FTSE SmallCap index to gain exposure to UK small companies, but you end up with a real ragbag. "You'll get companies that are non-UK, some that are in the middle of merger or acquisition activity and others that are on the verge of bankruptcy. I believe in genuine asset class investing, and simply going for the index doesn't always give you this," he explains.

To resolve this problem, he uses funds from Dimensional that sift the index and throw away anything that doesn't fit the criteria, leaving an investor with a pure asset class investment.

Some advisers prefer to use a combination of active and passive funds in their client portfolios. This is the case for Martin Bamford, a chartered financial planner at Informed Choice, who is happy to use passive funds where the market is well traded and highly liquid. For exposure to the US market, he uses the HSBC S&P 500 ETF, which has an annual management charge of 0.15%. Where this isn't the case - in emerging markets, for example - he uses active funds.

For more on the balance between the two fund types, read: Active versus passive: Which is best?

Because asset allocation is important in a passive portfolio, rebalancing is necessary to ensure unexpected risk doesn't creep in. Crabbe recommends doing this only once a year to keep down costs. "We have a rebalancing review once a year but we also have tolerances in place. If these haven't been exceeded, we'll leave the portfolio as it is. The difference in volatility won't justify the charges," he explains. He adds that he would also look to replace a fund if a cheaper one was launched.

The annual cost of a passive portfolio is typically 0.4 to 0.5%. The cost of the platform and ongoing advice is extra. The total charge can be 1.2 to 1.5%.

There is considerable debate over which passive vehicles are most appropriate. ETFs, especially the ones using physical replication, win favour with some advisers who see them as a low-cost, transparent way to gain market exposure.

Others are less keen. "I'm not averse to using ETFs in a portfolio, but we often find we can access cheaper institutional passive funds," says Witcombe. Funds from Vanguard and Dimensional, for example, can deliver annual management charges as low as 0.15%.

Where these options aren't available, advisers will use index-tracking unit trusts and open-ended investment companies. Although investment trusts can offer broad market exposure at low cost, they also employ gearing. "We avoid gearing, as it introduces a higher level of risk," says Patrick Murphy, practice head at Bluefin. "Passive management is all about capturing returns by gaining market exposure at as low a cost as possible."

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