The 5 April Isa deadline is fast approaching, meaning time is almost up for investors to make the most of this year’s bumper £20,000 tax-free Isa allowance.
If you are still wondering where to invest, it might be worth giving passive funds a second look.
In their purest form passive funds, also referred to as trackers, attempt to replicate the performance of a given index such as the S&P 500.
Funds invested in passive products rose by 38 per cent in 2017 from the year before
They seldom achieve this due to a phenomenon called tracking error but the divergence is typically small.
Trackers have gained popularity in recent years. According to State Street Global Advisors data, a record $464billion (£3.28billion) was invested in exchange traded funds, a common passive investment vehicle, last year. This represents a 38 per cent increase on from the year before.
The allure of such investments is easy to understand. For one, they typically cost less than actively managed propositions.
Active managers earn their corn by attempting to beat their benchmark market index by cherry-picking stocks and chopping and changing them to take advantage of perceived inefficiencies in the market.
However, trying to beat the index comes at a cost. Cash spent on the latest investment research and footing the salaries of the investment team – fund manager included – inflate the cost of active management.
This extra cost layer does not apply to passive propositions, which are essentially run by a computer algorithm and will buy all or the majority of the assets within the index they track.
What’s more, with active investments, there is no guarantee that they will perform better than the market.
In fact, a school of thought argues that the odds are stacked against actives over the long-run as market indices tend to be more broadly diversified and are therefore better shielded against economic cycles.
Put simply, you can pay more for an active which may or may not beat the market or you can pay less for a tracker which won’t beat the market but should match it.
But with so many options on offer, how do you choose the best trackers to invest in this Isa season? We’ve asked two experts in passive investments to give their top picks.
The experts’ top picks
Peter Sleep, senior investment manager at Seven Investment Management, said investors should always aim put their cash in regulated ‘UCITS’ funds – which have stringent safeguards for investors in place. He outlined his top picks below.
UK Equity – Lyxor Core Morningstar UK ETF
Ongoing charges: 0.04 per cent
The Lyxor Core Morningstar UK ETF is a new fund which launched this month. It costs 0.04 per cent, which is as cheap as chips.
A broad-based UK equity fund is the core building block for any investor. The ETF has 337 stocks and a good combination of large international companies and smaller UK-orientated companies.
UK Equity Income – Vanguard UK Equity Income
Ongoing charges: 0.22 per cent
I’m a fan of the Vanguard UK Equity Income Fund priced at 0.22 per cent.
This is a tracker fund rather than an ETF, although they are very, very similar.
Some caution is needed with UK equity income funds because you can end up biased towards quite volatile stocks.
The Vanguard fund is nicely balanced and has a decent yield of about 4.9 per cent.
Global Equity – Vanguard Global Small-Cap Index
Ongoing charges: 0.40 per cent
Again another tracker fund from Vanguard. The Global Small-cap Index fund priced at 0.38 per cent.
This invests in over 4,300 smaller companies from around the developed world. Historically smaller companies grow faster and show better returns than larger companies that may often have grown to their limit.
An Ethical ETF – UBS ETF MSCI ACWI Socially Responsible UCITS ETF
Ongoing charges: 0.48 per cent
There is an increasing number of ethical ETFs, but I am going to go for UBS ETF MSCI ACWI Socially Responsible UCITS ETF.
This is an ‘all countries’ ETF, so it covers both 47 developed markets and emerging markets, but not frontier markets (defined as smaller illiquid stock markets where investor protections are poor).
This ETF scores every company on various ethical, social and governance standards and then kicks out sectors with a negative social or environmental impact like gambling or alcohol.
The ETF costs 0.48 per cent. To reduce the risk of investing abroad this ETF is hedged into sterling.
A Bond ETF: SPDR Barclays Global Aggregate Bond UCITS ETF
Ongoing charges: 0.10 per cent
The SPDR Barclays Global Aggregate Bond UCITS ETF GBP hedged costs 0.1 per cent.
In the long-term, the king of investments is equities, but we know they can be very volatile and they are not for everyone, so more cautious investors hold bonds and accept a lower return for a less bumpy investment ride.
This ETF invests in high grade government and corporate bonds, what we call ‘supranationals’, like the World Bank, and high-grade emerging market bonds.
Finally it is all hedged into sterling to reduce risk further.
You get all that for the bargain basement price of 0.1 per cent. With 21,000 bonds in the index the ETF is highly diversified and SPDR have to work really hard for you.
ISA ESSENTIALS FOR SAVING AND INVESTING
Mark Taylor, chief customer officer at investment platform Selftrade, favours investing passively through ETFs.
‘An ETF gives you access to a full index or market without the need for lots of separate transactions,’ he explains.
‘ETFs bring together the portfolio diversification of a traditional fund with the flexibility of a shareholding.’
Here are his top picks.
Starting out – DB X-Trackers MSCI World Index
Mark Taylor of Selftrade: ETFs offer the portfolio diversification of a traditional fund
Ongoing charges: 0.19 per cent
It is always sensible to have a core fund at the heart of your investment pot – a fund that tracks the main global markets.
One fund that does just that is the DB X-Trackers MSCI World Index.
This fund is designed to track the largest companies trading on stock markets globally.
About 59 per cent of the fund is exposed to the US, 9 per cent in Japan and about 5 per cent is in the UK.
This fund is a good start when getting going as it spreads the risk round the world but takes in the major markets. This fund has low yearly ongoing charges of 0.19 per cent.
Buy British – DB X-Trackers UK FTSE All Share
Ongoing charges: 0.20 per cent
UK stocks continue to remain out of favour with investors as uncertainty over Brexit weighs, but I still think there is some value there.
If you are looking for a fund that tracks the performance of the UK market on a broad basis and is not confined to just the top 100 companies then take a look at the DB X-Trackers UK FTSE All Share.
This fund has a low yearly ongoing charge of 0.20 per cent and is an aggregation of the FTSE 100, FTSE250 and FTSE Small Caps indices.
Europe (excluding the UK) –iShares Core Euro Stoxx 50 UCITS ETF
Ongoing charges: 0.10 per cent
Europe has had a tricky couple of years, but we’re starting to see visible signs of economic recovery.
If you therefore believe that the prospects for Europe, without the UK, are looking good then my preferred tracker fund for this would be iShares Europe ex-UK50.
The fund aims to deliver the return of the EuroStoxx 50 index with an ongoing charge of 0.10 per cent.
Seeking an income – SPDR S&P UK Dividend Aristocrats ETF
Ongoing charges: 0.30 per cent
Many investors prefer to take an income from their investments through dividends.
Don’t forget that the allowance for taking tax-free dividends reduces from £5,000 to £2,000 from 6 April.
So if you are investing for income then it’s best to make use of your Isa allowance to protect your income from the tax man.
The importance of dividends being reinvested cannot be underestimated when it comes to long-term growth.
I would therefore also look at an ETF that tracks high-yielding UK companies that have held or increased their dividends consistently, such as SPDR S&P UK Dividend Aristocrats ETF.
Call me old fashioned but there is still something to be said about companies that make profits and return a share of those profits to customers in the form of dividends, rather than over-valued hype on a promise.
The top holdings include G4S, the outsourcing firm, and the pharmaceutical company, GlaxoSmithKline. The ongoing charge is 0.30 per cent.
Commodities – ETFS All Commodities DJ-UBSCI ETF
Ongoing charges: 0.54 per cent
If you believe population growth on the planet will increase the demand for commodities then take a look at the ETFS All Commodities DJ-UBSCI ETF.
I am convinced that we will see increasing pressure on commodity prices over the next few years.
The United Nations forecasts that the planet’s population will hit 10 billion by 2050 – more than a 40 per cent increase against today’s number.
This will put pressure on commodities that we all need to support our daily lives.
This ETF tracks a broad-based commodity index, the Dow Jones/UBS. About a third of the fund tracks agricultural commodities, like wheat and corn, while another third tracks energy related commodities like oil and gas. About 17 per cent is in precious metals.
An investment into a commodity fund is also another way to spread your risk and diversify.
The ongoing charge is 0.54 per cent, which is on the higher side but reflects the specialist nature of tracking the commodity markets.
Commodity ETFs: A risky diversifier
Investing in commodities is a good way of diversifying a portfolio that also holds shares, bonds and property.
But they are also considered a higher risk proposition. This is because commodity prices are determined by demand, supply and sentiment – and can be very volatile.
It is also important to watch out for currency risk.
When a fund generates a return from its overseas positions, the cash is usually converted into the currency the fund holds – typically pounds sterling or US dollars.
The trouble is, currency exchange rates are in a constant state of fluctuation. So if the exchange rate shifts, so does the return.
The risks involved with this type of investment are not the easiest to navigate so make sure you do your research before choosing such a strategy or consult a financial adviser.
For more on commodity ETFs, click here.