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What to watch out for with passive funds

by , 23 August 2013

Investing in passive funds does have its advantages. But, there are a few things you need to watch out for. Read on to find out what you need to be aware of with passive funds…

Passive funds track the underlying market, Phil Oakley explains in MoneyWeek.

To invest in passive funds you can either invest through a tracker fund or an exchange traded fund (ETF).

Passive funds offer you a cheaper alternative to investing in active funds. Active funds carry high costs and fees in comparison to passive funds.

Check the ‘tracking error’ of the passive fund

But there’s something you need to watch out for: Tracking error.

You can’t expect a tracker or ETF to match its index with absolute precision. Because you have to pay an annual fee, you'd expect it to underperform the index by at least that much.

But there are other costs involved too.

For example, trading costs and taxes will also add to the costs of running a passive fund. And depending on the tracking method used, there may be other costs that aren't included in the annual fee.

All this means is that some trackers and ETFs will follow their index better than others.

So before you buy, compare the past performance of the fund (which you should be able to get off the fund factsheet – available online from the provider’s site) to the performance of its index.

You're looking for the one that shows the least divergence from the index. In other words, the one that tracks its market best.

After all, there's no point in paying a low annual charge if you end up with a fund that then loses you more money than it saves due to tracking error.

Remember: Always make sure you know what passive fund you're buying!

Passive funds look straightforward. And most of the time they are, which is one of the reasons why you should like them.

But make sure that you know what you're buying.

ETFs in particular are very useful, but they can contain potential pitfalls for the unwary.

More complex ETFs offer ways to profit when markets go down, or profit from more exotic asset classes, such as soft commodities or currencies.

There's nothing wrong with these products as such, but you need to be aware of the risks too.

There you have it, what to watch out for with passive funds.

What to watch out for with passive funds
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