Conal Gregory: Get on the right track with the cheapest way to build a portfolio

Investing in an index of recognised companies makes decision-making far easier and will certainly be the cheapest way to build up a portfolio in the stock market.

Bernard Wheeler, left, of Knight Capital, and John Panin of JNK Securities, work on the floor of the New York Stock Exchange on Wednesday, June 6, 2012. An early charge on Wall Street Wednesday put the Dow Jones industrial average on track for a second day of gains, up 154 points at 12,242 in the first hour of trading. (AP Photo/Bebeto Matthews)

It means that a raft of shares can be purchased which is likely to be far more than almost any individual can amass on a company by company basis. In turn, this means the volatility is reduced immensely.

The world’s leading individual investor, Warren Buffett, urges passive over active. He has left instructions that on his death, all personal assets should be placed in trackers for his beneficiaries.

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Trackers aim to replicate the performance of a particular asset class or index in one of three ways:

Full replication of all the underlying constituents of an index

Stratified sampling where a representative sample is held

Optimisation where a computer model selects the sample of securities.

For investors, there is a competitive advantage in saving this way. Tracker funds are usually much cheaper than actively managed collectives. The typical annual fee is around 0.1 per cent which compares with 0.75 per cent or even more for an actively managed fund.

However, “whilst a passive approach should be cheaper, there are some caveats”, warns Kelly Kirby, chartered financial planner at adviser Chase de Vere in Leeds.

Kirby says some trackers are more expensive, such as the Virgin FTSE All-Share fund which recently reduced its annual charge from one per cent to 0.6 per cent and yet has over £2.7bn invested in it.

The likely annual cost quoted for a tracker is not the full sum as there will be a further fee for the ‘platform’, which is the wrapper. This allows the investment to be held in a tax-efficient way through an ISA or SIPP. Expect a typical further charge between 0.25-0.45 per cent.

“Don’t assume that cheap means lower returns – the evidence is mixed,” says Moira O’Neill of Interactive Investor who compared the Vanguard LifeStrategy range, which invests in passives against 800 multi-asset funds, both active and tracker. “They performed strongly against peers for just a fraction of the cost, just 0.22 per cent.”

A broad exposure through a tracker is an ideal way for a child or novice investor to start investing.

Whilst some investors find the simplicity of this low-cost approach appealing, many others opt for them as they do not believe managers can consistently outperform a tracker.

Over 10 years, only 25 per cent of active funds beat passives, according to figures from S&P Dow Jones.

Active managers have consistently struggled to beat trackers in more efficient markets, such as American equities and large capitalised UK companies. However, they should be able to add value in under-researched markets, like small companies, or in less mature ones like emerging nations.

It is important to realise that trackers give greater weighting to the largest companies. Yet, over time, small and mid-cap stocks, which are often dynamic firms, should be expected to outperform larger which may mean losing out on better performance which could be achieved through selection.

Trackers should come with a warning that they are not a low risk option.

Those tracking a stock market index are completely exposed to the performance of that index which in some cases can be heavily concentrated in certain sectors.

Often a UK tracker is chosen without the investor realising that it may follow only a small number of shares and not be representative of the economy. Whole sectors may be allocated minute representation, such as property.

By its title, the FTSE 100 tracks the largest 100 companies quoted in London but this means 20.5 per cent is invested in financials alone and 16.8 per cent in energy. One company (HSBC) accounts for 7.7 per cent of the whole index.

If the priority is to invest in the UK economy, seek the FTSE 250 where around half earnings come from abroad by comparison with the FTSE 100 which depends 75 per cent on overseas earnings.

Over the last five years, the FTSE 250 has returned 43.5 per cent, the All-Share 35.2 per cent, the 350 34.8 per cent and the 100 33.1 per cent. By size, the FTSE Small Cap has achieved 46.5 per cent.

If looking for the US, opt for the S&P 500 index, which is weighted by market capitalisation, not the Dow Jones which is just 30 stocks which are weighted by their share price, reflecting bizarre distortions.

Full replication may not produce the right result.

The boom and slump in technology is evidence enough of the dangers. Baltimore Technologies saw its valuation in the dotcom boom leap from £35m in early 1999 to £7bn in March 2000 when it automatically joined the FTSE 100. Three years later, its main business was sold for just $5m.

Other failures from that time include Cable & Wireless Communications, Freeserve, Psion and Thus, all of which investors would prefer to forget.

Apart from the underlying portfolio and total costs, other factors to consider are the tracking error (the disparity between the tracker and the index followed), how the whole index is held or if it is a sample and crucially if actual purchases are made for all holdings (as opposed to borrowing from hedge funds or vice-versa). The latter practice can expose the tracker fund to significant risks.

Kirby feels the sensible approach is to hold a combination of active and passive funds, using the former where the manager has a better opportunity to outperform. For trackers, Kirby tips three providers: HSBC, Legal & General and Vanguard.

For the Far East, decide whether China and Japan are to be included. For a low cost passive without Japan, which proved to be a sluggish economy for a long time, consider iShares Pacific ex Japan equities Index.

If keen on good dividends and favour utilities but are concerned over the threat of nationalisation in the UK, look at iShares S&P 500 Utilities, which has 29 holdings or the Lyxor World Utilities with 56 per cent in the US.

If looking to combine a fund with little investment in healthcare, correct the balance by opting for Legal & General’s Global Healthcare and Pharmaceuticals Index Trust.

For less mature lands, two good choices are the Fidelity Index Emerging Markets fund and Dimensional Emerging Markets Core Equity.

Both should be regarded as long-term savings, at least five and ideally 10 years to realise their potential.