A passive management approach involves creating a portfolio that simply mirrors an index, such as the FTSE 100, as opposed to trying to beat it. Followers of this style of investing believe that markets, at all times, reflect all information, a theory otherwise known as the Effective Market Hypothesis.

Under this theory, the buying and selling of securities comes down to a game of chance, not skill, and if the markets are efficient, there is no possibility of ever buying a stock at a bargain price.

This is where index-tracking funds play their part. They first hit the retail market in the 1990s and they are the most popular form of passive management.

These funds follow the belief that no traditional fund manager can outperform the index over the long term, therefore making index tracker funds a better option for investors.

A core holding
Virgin Money spokesperson Grant Bather explains, ‘Passive funds allow the investor a broad scope to invest in. They continue to be a good entry level for first-time investors and a staple of many seasoned investors’ portfolios, due to their relatively low risk and their historical performance. As such, an index tracker is an important part of any portfolio and should be considered a core holding.’

The main benefit of using an index-tracking fund is the low cost. Because there is no need for tracker funds to have teams of experts monitoring individual companies, and there are no extra costs involved in the regular buying and selling of different shares, they are very cheap to run.

For example, a traditional unit trust or open-ended investment company (OEIC) could charge an initial fee of up to five per cent and an annual management fee of around 1.5 per cent of the fund’s value per annum.

In comparison, tracker funds typically don’t charge an upfront fee and only charge up to
one per cent per year.

Jonathan Latham, marketing director at Wealth Direct (part of Legal and General) suggests, ‘Tracker funds can cost anything from 0.3 per cent right up to one per cent, but what investors must do is make sure that they are clear about all the charges. For example, are there any other administration charges? We have gone down the route of being a very low-cost provider, and many others are transparent with their charges too.’

Delivering what they promise
Judging by past performance, tracker funds have provided a good deal for investors. When markets are rising they have been among the best performers. However, in bear markets, such as we are currently experiencing, tracker funds start to slip.

As Tony Ahearne of independent investment research website MoneySpider.com points out, ‘Around five million investors currently hold index tracking funds, which are marketed as easy-to-understand, low-cost investments. But in this current market they are bad news.’

He adds, ‘In this investment climate, a tracker can only go one way, and that is down. There is little point paying low charges if you are being rewarded with below par performance.’

Indeed, major funds such as Legal & General’s UK 100 Index, Scottish Widows’ UK Tracker and Virgin’s hugely popular UK Index Tracker have all fallen sharply in the past 12 months.

Jonathan Latham says, ‘I think that generally the market has made many investors wonder about where they should be putting their money. You only need to look at financial services as a whole to see that people are investing less money, and this is partly due to them needing more for their day-to-day costs and partly because they are trying to find the best vehicle in which to house their money.’

But he adds, ‘However, once the market has hit the bottom, confidence will improve and more money will flow back in, but at the moment investors have a very interesting choice to make as to whether they go down the passive management route.’

Models of efficiency
Index tracking funds are much more effective in efficient markets, such as the UK and the US, because the transparency of the financial systems makes it harder for active fund managers to seek out bargain stocks that have been overlooked.

‘Index trackers do tend to work best in efficient markets, but for those with a long-term investment horizon, index trackers can also work in emerging markets,’ suggests Grant Bather. ‘Volatile markets, or markets where inefficiencies are deemed to be present, such as emerging markets, offer greater opportunities for active management, but they are not without risk.’

The range of index-tracking funds is also increasing as markets, and those who invest
in them, become more sophisticated. The debate as to which passively managed product is better has been ongoing for some time among investors and advisers alike, but the difference ultimately comes down to tracking error.

You may find, for example, that a regular index-tracking fund has an error margin of around 0.5 per cent, which means that it is not tracking the index perfectly. As Manooj Mistry, head of db x-trackers UK explains, this allows the fund to cover the costs of reinvestment. ‘Regular index-tracking funds buy and sell units in small sizes directly from investors, which means that the fund will always hold an element of cash, because it needs to pay for the proceeds of any redemptions.’

The ETF option
Mistry’s firm, however, specialises in providing exchange traded funds (ETFs). Similar to traditional index funds, ETFs are designed to track a particular exchange or index and allow investors to buy into a range of companies through a single quoted share.

ETFs are primarily linked to established market or sector indices and allow investors to access large-caps, mid-caps and small-caps. Their introduction has opened up more opportunities to investors that favour passive management.

Mistry suggests that ‘ETFs are a building block in a portfolio, giving investors flexibility.
‘It is not a question of just buying and holding, but investors have the opportunity to change the way they invest and be much more dynamic.’

The main reason ETFs are gaining popularity among investors is because of their low costs. Mistry explains, ‘If there is less activity at fund level on an ETF, this means that management costs can be kept low. If you look generally at ETFs, they will have a lower management fee compared with a regular index-tracking fund.’

He adds, ‘There are two levels of costs involved with ETFs. When you are buying an ETF from a broker you will have to pay a brokerage fee, which can be either a flat fee or a percentage, depending on the broker.

‘You will also have to pay a management fee for the ETF.  So, for example, a FTSE 100 ETF would have a management charge of around 0.3 per cent. All major markets should be 0.5 per cent or below; obviously emerging market ETFs are a little more expensive, typically around 0.65 to 0.7 per cent.’

Mistry asserts, ‘The way that ETFs are constructed means that they should track the index much more efficiently.

‘It is only specialist market-makers that can carry out subscription redemptions, and they tend to do it in bulk size, which means there is no surplus cash.’