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Passive investing – what is it, and how does it work?

We take a look at where it all started for passive investing and why tracker funds have become more popular with investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Passive investing is one of the simplest and easiest ways to invest in the stock market. Tracker funds have been around for over 40 years and are offered by a range of investment companies. But where did the notion of passive investing first begin and how does it work?

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice.

How it started

Passive investing was made available for retail investors in 1976 when Jack Bogle, founder of Vanguard, created the world’s first retail index fund. Appropriately named the “First Index Investment Trust”, it tracked the S&P 500 – an index of the 500 largest companies in the US.

Bogle’s motto, “Don't look for the needle in the haystack. Just buy the haystack”, neatly sums up passive investments. It suggests that simply tracking an index, rather than attempting to beat it, protects investors from active managers’ human error.

As with all new ideas, it was met with challenge at first. The investment space was ruled by active managers and, unsurprisingly, they weren’t keen on an approach that was cheaper (and in some cases better) than their stock picking.

Over time the benefits of passive investing came to fruition, leading to the industry we see today.

As with all investments, passive funds go up and down in value so investors can get back less than they originally invest.

A growing industry

Since 1976, passive investing’s popularity has risen. Tracker funds now account for around 20% of investments in Europe and 41% in the US – almost double their market share compared to ten years ago.

The growth’s been led by several global players, including BlackRock, Vanguard and State Street. As of January 2021, Vanguard now manage over $7 trillion worth of investments globally.

In the UK there’s also groups such as Legal & General, which we believe offers some of the best simple and low-cost tracker funds in the market.

How they work

Passive, also known as tracker, funds aim to track the performance of a particular index, or stock market. For example the FTSE 100, which is made up of the UK’s largest 100 companies. This approach is different from actively-managed funds where professional fund managers invest into a select number of companies, with the aim to beat the performance of an index.

Most tracker funds typically invest in every stock that makes up the index it’s trying to replicate – known as full replication. Some funds won’t invest in every stock, but they’ll hold a sample of shares which represent the wider index. This is known as partial replication.

Either way, buying and selling companies involves costs which can eat away at performance. To keep the fund’s performance as close to the index as possible, tracker funds use techniques like reinvesting dividends at an appropriate time to keep costs to a minimum.

For example, the Legal & General UK 100 Index fund on our Wealth Shortlist tracks the FTSE 100. The fund buys every stock in the index, keeping performance in line with the benchmark. By fully replicating the index, the difference in performance between the fund and benchmark is very low – averaging 0.1% over 10 years.

A glance at the five-year performance table shows in some years the fund has tracked the index closer than others. We’d normally expect performance to fall behind its benchmark over the long term due to the costs involved with running the fund.

Annual percentage growth
April 16 -
April 17
April 17 -
April 18
April 18 -
April 19
April 19 -
April 20
April 20 -
April 21
FTSE 100 TR 20.0% 8.5% 3.1% -17.1% 22.2%
Legal & General UK 100 Index 19.6% 8.5% 3.0% -14.8% 17.7%

Past performance is not a guide to the future. Source: Lipper IM 30/04/21, dividends reinvested

More about the Legal & General UK 100 Index Fund including charges

Legal & General UK 100 Index Fund Key Investor Information

What does this mean for investors?

Bogle’s venture kickstarted the passive industry, and it shows little sign of slowing. Markets across the globe can now be easily reached using tracker funds. As passive companies continue to develop, they benefit from their scale which could help investors track indices at even lower-cost.

An index-tracker fund is one of the simplest ways to invest, and we think these funds could be a great, low-cost starting point for a portfolio aiming to deliver long-term growth. They could help diversify a portfolio focusing on active managers or individual shares and bonds.

For investors interested in tracker funds, the Wealth Shortlist has a selection of funds selected by our analysts for their long-term performance potential.

The Wealth Shortlist includes funds across a range of sectors, and risk levels that won’t be right for everyone – it isn’t personal advice.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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