So, what is it exactly?
A passive index fund allows investors to track the performance of a pool of investment assets at low cost.
First off, what does “passive” mean?
Broadly there are two types of investment management: one is “passive” and the other “active”. Passive management gives investors access to specific parts of the market, typically based on a set of rules that the investor is happy with. Because it is rules-driven, it strips out human emotion, and there is clarity on whether or not company A or B should be bought or sold and for that the investor tends to pay lower fees than for choosing “active” funds.
With an “active” fund you are backing and so paying for the skill of the active manager and her or his team of analysts to pick companies that together may (or may not) outperform year on year. Unfortunately the research has not been great in showing that active managers can consistently do well each year compared with the general market.
But an index does not have to be based just on the size of the company (although many are), the rules can be broader and cover a range of countries, asset classes, sectors or a specific type of investing such as only selecting companies that meet pre-set environmental, social or governance criteria, e.g. no weapons or alcohol, carbon footprint below X tonnes per annum to name a few points.
What is an index?
In the news you are likely to have seen the FTSE 100 mentioned when equity markets are being talked about. This is often taken as an indicator for how the UK equity market is performing as this particular index captures the performance of the largest 100 (or so) companies listed on the London Stock Exchange, so the likes of Vodafone or HSBC and so on.
The S&P 500 is from over in the US, with exposure to, you've guessed it, the largest 500 US companies. But an index does not have to be based just on the size of the company (although many are), the rules could be broader and cover a range of countries, asset classes, sectors or a specific type of investing such as only selecting companies that meet pre-set environmental, social or governance criteria, e.g. no weapons, tobacco or alcohol.
What are the pros?
A key advantage of index funds is that they are a low cost option, charging just a fraction of a percentage point each year (0.05% to 0.25% being the general range of the ones we use, some more specialist ones may charge slightly more), while many active funds, for instance, may charge between 1-2% per annum.
Passive funds are low-cost because they aren’t trying to guess individual winners in the stock or bond markets but instead are designed to track an entire group of investments. That means fund managers don’t need to make large numbers of trades which costs money or hire expensive analysts to try and work out which companies might do well.
Is there anything to be careful about?
Index funds are funds and still have fees. While these fees are much lower than those of active funds, you could technically avoid those fees too by going out and buying all the individual stocks or bonds the fund invests in. It would be time-consuming, but it would cost less to hold them but far more to do all the trades.
As with all diversified funds, the chances for big gains are smaller than if you’re buying an individual stock (as are the chances of losing your shirt).