Buying a passive fund does not mean taking a passive approach

Passive investors cant take a back seat with their analysis, says Peter Sleep.

There is no hiding it, really – putting together a portfolio that is right for you is complicated, even if you use tracker funds or exchange traded funds, which are often misleadingly called ‘passive’ investments.

It takes considerable work and research to find an investment portfolio you are happy with and that meets your needs. It can help a lot if you speak to a financial planner, but even then, some preparation is recommended.

Do some homework

Before you meet your financial planner, do some background reading. You will get more from the conversation if you understand the basic ingredients of a sensible portfolio. Many potential investors understand what an equity is, but not other investment basics such as the definition of a gilt or treasury. That’s understandable, but you should really be clear on these before you proceed further, so spend some time reading around and researching.

Establish your needs and realistic ambitions

Before investing anything, you should also think about the return you need to achieve with your savings, and your attitude to losses too. You should not expect an annualised return of anything more than say 7% to 8%. And you can only achieve that if you invest 100% in equities, which means accepting a lot of risk.

If you are a ‘balanced’ investor – typically investing around 50% in bonds and 50% in equities – then your expected long-term returns will be less, and if you are a cautious investor you should expect returns of only 3% to 4%. Of course, that should also mean the potential losses are smaller.

With realistic targets established, the next challenge is to build the multi-asset portfolio most likely to meet those needs, and that means more homework.

Understand how passive investments behave

Years ago, when passive investing was in its infancy, there were few choices and that made it simpler. Not any more. You really need a good understanding of what the exchange traded funds (ETFs) and funds that you see on your favourite fund supermarket are trying to achieve, and how much they might bounce around – what sort of loss you might incur in a bad year and what sort of return you might expect in the very long term. You need to be clear also about what you are buying (for example, what currency it is in, or whether it is ‘hedged’, to protect against currency movements).

Ensure that any fund or ETF you invest in is a Ucits fund, in order to receive basic investor protections. It is not unusual for funds to be based in the EU, for instance in Luxembourg or Ireland. If that is the case, ensure that it has UK tax reporting status, otherwise you could get some unexpected tax bills. Before you buy, read the factsheets and Key Information Documents.

Actively manage your portfolio

Fund selection can be easy or hard. You can combine many funds and ETFs, or you can just buy one or two. It is all down to you. For equities, you may want to break the world up into regions or you could buy a global product. Similarly for bonds, you could buy an all-encompassing ‘aggregate’ fund or you could break up your bond allocation into regions or ‘quality’ buckets.

Having done all this difficult homework, you then have to actively manage your portfolio. You should rebalance the holdings quarterly or annually. If, for instance, your US equities have soared in value but your emerging market equities have stumbled, you may want to take a little bit of profit in the US and reinvest it in the emerging markets, to ensure the US portion does not come to dominate the portfolio over time.

You may want also to actively take advantage of specific situations as they arise. For instance, you might feel that sterling is too cheap and one way to prevent losses is to buy hedged ETFs. Alternatively you might decide there are opportunities in UK mid-cap equities ahead of Brexit, so you could buy a FTSE 350 tracker fund.

The solution

Many people like the benefits of passive investing – the lower costs and the assurance of capturing the aggregate performance of a market (which many more expensive active managers can struggle to beat). But many of these investors are looking for an easy solution too. Easy costs a little more, but the combination of seeing a good financial planner and buying one of the actively managed passive one-stop shop funds available from various providers (including the AAP range available from 7IM) can be safer in the long run, and deliver far more than just peace of mind.

Peter Sleep is a senior investment manager at Seven Investment Management (7IM).

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