One of the big attractions of passive investing is that you don’t need to give it much thought. But that’s not to say there are no decisions to make.
What level of risk?
A crucial decision to address at the outset is your asset allocation. This should reflect your capacity for risk.
There are passive funds for every type of publicly traded equity and bond. Generally, as we mentioned last time, global equity trackers are best. But unless you’re a new investor, you will probably want to allocate part of your portfolio to short-dated government bonds, which are very much safer.
So you should either have an equity fund and a bond fund, or, to keep things really simple, go for a single fund that give you exposure to both
Whole of market or factor tilt?
Most passive equity funds are what’s called market-cap weighted. In other words, they invest in every stock in a particular market, and each stock is wighted according to its market capitalisation. So the stocks with the biggest market cap have the biggest weighting.
Alternatively, there are funds that invest in a particular type of stock. So, for instance, you could invest in the stocks of small companies, or in value stocks — companies that, according to a particular metric, are trading at a lower price than their actual value warrants.
These so-called factor funds should, in theory, outperform the wider market over the long term, But you can’t be certain they will, and you may need to be extremely patient.
ESG or mainstream?
The next decision is whether you want an ESG fund or a mainstream equivalent. ESG stands for Environmental, Social and Governance (read more on ESG investing here). These funds are designed to deliver benefits for the environment and wider society as well as a financial return.
Passive ESG funds operate in different ways. Some have a negative filter (they weed out polluting stocks, or firms that don’t treat their staff well, for example). Some have positive filters (they include firms that score well on ESG issues). Others won’t exclude so-called “sin stocks” but will give them a smaller weighting compared to firms with a higher ESG score.
Index fund or ETF?
Finally, you need to decide whether you want an index fund or an ETF, or Exchange Traded Fund (read more on where to invest in ETFs here.
Unlike index funds, ETFs can be traded on an exchange during normal trading hours, although that’s a not a reason for ordinary investors to use them.
More importantly, they’re generally more transparent and slightly cheaper, which are genuine advantages.
But beware: not all are ETFs are passively managed.
Concluding remarks on choosing a passive fund
Those, then, are the four main choices to make. Whatever your personal preferences, you should find at least few funds to choose from.
Remember, cost isn’t everything, but on the whole, the cheaper the fund the better. You should also choose a fund with a low tracking error — in other words, that tracks the relevant index as closely as possible.
Finally, whichever route you go down, make sure you invest for the long term. More important than the fund you pick is your ability to stick with it, whatever the future holds.