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 02.07.2015
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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 ETF in the UK investing in the FTSE 100 for as little as 0.07% a year or an ETF in Hong Kong tracking the Hang Seng Index for as little as 0.10%. 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 a passive-fund investor.

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.

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.

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 in the U.S., 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. Similarly, “China” exposure can be quite different when there are the offshore exposures (e.g. H-Shares) and the onshore exposures (A-Shares).

Likewise, many funds track MSCI indexes, but some other funds track FTSE indexes. One key difference: FTSE counts South Korea as a developed market while MSCI counts it as an emerging market.

Investors should read the passive fund’s prospectus closely to find out what index it tracks.

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 difference” refers to gaps in the performance of a passive fund relative to its benchmark; and “tracking error” refers to the standard deviation of return differences between the fund and its benchmark.

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

Investors can check the fund’s performance relative to the benchmark, and relative to its competitors that track the same index.

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. Overall, you should make sure the overall allocation meets your needs.

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Adam Zoll  Adam Zoll is an assistant site editor with Morningstar.com

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