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By Jeremy Glaser | 09-13-2011 11:11 AM

Tips on Picking the Best Passive Fund

Look for low fees and make sure you understand the underlying index before jumping into a passive fund, says Morningstar's Paul Justice.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. It's Active/Passive Investing Week at Morningstar.com. I'm here with Paul Justice; he's the director of North American exchange-traded fund research. We'll take a look at getting the most out of your passive investments.

Paul, thanks for talking with me today.

Paul Justice: It's great to be here.

Glaser: So, when investors are thinking about investing passively, investing in funds that track in indexes or track the broad market, one of the big things they have to choose is the index they are going to be tracking. Could you talk to us little bit about different index instructions, that is what investors should keep in mind when they're trying to figure out exactly what fund they should be in?

Justice: Fifteen years ago this was a pretty easy decision. There were a few index families, most of them were constructed similarly, say, going after a market-cap-weighted approach. But now with so many ETFs coming out, there are a lot of ETFs that take some pretty abstract strategies and use the word "indexing" maybe going a little bit too far. We do have a lot of cap-weighted indexes, which are going to be the very passive ones that are going to have low turnover and generally very low costs. But you also have to sort through some of the other names out there that will take an old strategy, say the S&P 500, and do something unique to it, say equal-weight it or put fundamental factors in there to pick the stocks in there. Now technically it's still in index, but it's not the same type of index that your grandfather is used to.

Glaser: So, it might be rules-driven, so you can predict it. But it's going to not be as passive as maybe some investors are looking for?

Justice: Right. It's going to give you a lot of traits that an actively managed fund would, and what are those going to be? Generally they're going to be higher turnover. You're going to have, I guess, less conceptual ability to know what stocks are going to be in there at any one point in time. And they're also probably going to have some higher fees. I'm not saying that these strategies can't work for you, but you need to be careful and make sure that you're very comfortable with the quantitative nature of the way the fund is going to pick it before you jump in. Otherwise, you're just picking something out of a barrel.

Glaser: So, what about the funds that actually track these indexes? Oftentimes, many funds track very similar indexes. How do you choose between all of those different options out there?

Justice: So, once you've narrowed down the lot, in that you know what category and what type of approach that you want to take, you have to start looking at some of the details. Who is going to give you the best execution on that strategy? Oftentimes, cost is going to be the biggest factor there. You're looking at things that are relatively commoditized. So, you want to make sure that you're getting a fund with the lowest overall expense ratio, and that's not the only component you have to look at. The turnover within the portfolio, how much tax cost is that going to generate for you, is another important consideration.

Finally, it's actually the holdings that are going to make up that portfolio. You can look at a large-cap growth fund from one family and a large-cap growth from another. They're going to have vastly different holdings. If you're going to pair that up with a value fund, well, you might get overlap if you're crossing between index families. So, I think it's important for you to understand the methodology that the fund itself is using to select and pair it up with index funds within that same family to get the best experience.

Glaser: Certainly, you can get indexes in both the open-end funds and ETFs. What are some of the pros and cons of both of those structures?

Justice: Well, with mutual funds, oftentimes, if you're going to be putting in smaller amounts of money very frequently, that's going to be the better structure for you, so you don't incur the transaction costs. But if you're going to move a larger lump sum of money and you can find an ETF that's going to have a lower cost for you--the lower expense ratio--that probably would be a good bet. Move that sum of money right there, get the exposure, and rebalance once a year or wherever you timeframe fits.

Glaser: So, a universal answer there, it really depends a lot in your personal situation.

Justice: Yeah, and you know, you're really targeting the destination, not the vehicle. If you are an indexer, you're trying to keep costs low, keep that turnover low, and get the exposure you want. So, any one of these is going to reach that point, so it comes down to which one is going get you the better cost at the end

Glaser: Let's talk a little bit about portfolio construction. A lot of investors want to make tactical bets to be overweight small caps, large caps, or whatever it might be. What should they keep in mind when they're building a portfolio of passive funds?

Justice: When you're building a portfolio of passive funds, generally, it's my opinion that you should stick within the same index family to minimize that overlap, and make sure you're targeting the factor that you're looking for. A lot of people understand the value premium; over a decade or longer, value tends to outperform growth.

So, it's perfectly logical to go ahead and overweight value stocks and even small-cap stocks, but you want to do so in moderation. You don't want to give up the diversification that holding a broad portfolio will give you. You just want to take some small bets on those angles because a lot of people will tell you, value can underperform for a long period of time and could be painful.

Glaser: Yeah, we've definitely seen that. Paul, thanks a lot for your thoughts today. I really appreciate it.

Justice: My pleasure.

Glaser: From Morningstar, I am Jeremy Glaser.

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