The risks of passive investing

Kira Nickerson on the risks investors need to consider when entering passive funds.

Investors entering passive investment funds need to be careful they understand
what it is they are buying. Active funds are often seen as carrying a higher risk level but tracking funds are not without their pitfalls and as this area of the market expands, greater attention is warranted.

Tracker funds

Peter Robertson, head of retail at US passive management giant Vanguard, notes there are several ways tracking funds operate and it is vital consumers know which one they are buying.

There are funds that replicate the index they follow, those that track using a sampling, and then there are products which use derivatives to gain index exposure. Some ETFs tend to use the latter, not holding the physical stock at all. Robertson noted with these types of products, counter-party risk issues arise.

The risk in funds that use a sampling approach is they will have a greater deviance from the index they are supposed to be following. As they are not a direct representation of the actual holdings and weights in an index, returns will be skewed away from its returns and the tracking error can be wider than investors might otherwise expect. Added volatility in the market does not help as constituents move in and out and weightings fluctuate. Robertson notes managers can also get the sample wrong, causing occasional out performance but also more severe underperformance.

Missing out on the market

Jonathan Willcocks, managing director global head of sales at M&G, says another element is whether or not the income from the index is being included in returns. Considering the majority of long term total returns comes from the income portion, investors may be missing out on the best of the market if they are in a tracker that excludes income payments from the index constituents. “They may access the market but without the compounding effect of income they miss out on the returns the market can offer,” he says.

Robertson notes the most popular way to run a passive fund is via replication but this too features issues and requires scrutiny and more active decision making from investors. A fund that replicates the index needs to be large in size if it is going to be accurate, he says. If the portfolio is following a large index, ie: the S&P 500, then getting appropriate weights in each position takes bulk assets.

Choice of index

Vanguard chooses the broadest index available, preferring to track the FTSE All-Share or S&P 500 rather than smaller indices such as the FTSE 100. Robertson says the more focused indices may do well if small or large cap outperforms while the broader indices have both constituents.

“You are taking a bet if you go for a restricted index. By using a broader index your holding is more diversified and so is the risk,” he says.

The bigger indices also have the advantage of lower turnover as there are not companies dropping in an out of the top 100 or top 50 positions. With lower turnover comes lower costs and passive funds with low costs tend to be able to feature a better tracking error. Still, he says, such an approach requires economies of scale so fund size is important in tracking the big indices. Managers of passive funds have to bear transaction costs with fund inflows and outflows. With small sized funds these costs can be higher as the amounts are lower, whereas a larger fund does not have the same issue as it has economies of scale.

Willcocks does not necessarily agree that the broader the index equals fewer issues. Even the generalist indices are rebased, with stocks moving up to take greater weightings causing trackers to take greater stakes. This tends to happen after a company has performed well, which means the tracking fund is buying as the share price increases. This can be exacerbated by market trends. For instance, Willcocks notes the tech boom of 1999 led to an increased representation towards tech stocks in the FTSE. However, the index re-balanced towards tech stocks just as the market hit its peak in March 2000. “Passive investors would have missed the ride up and they got the full weighting towards tech at the peak so were forced to ride it all the way down.”

The index people choose is another component of risk. Obviously the S&P 500 has very different characteristics than a China index fund would possess. Robertson again points out that in looking at emerging regions and smaller country-specific indices, investors may be better off in a broader index allocation. By using the broad-based MSCI Emerging index rather than a country specific one, investors have a broader sweep of exposure rather than being tied to one economy, which may be volatile. The wider index for emerging market exposure also contains the largest and most liquid companies, he notes. An active manager might be better able to discern the value opportunities with smaller company emerging market exposure than an index.

Don’t look back

It used to be that to assess the quality of a tracker, investors would look at its performance, tracking error and its fees. Tracking errors are backwards looking, complex and groups can generally calculate them differently. Robertson says there even two general definitions of tracking error – the colloquial one, meaning the basic difference in performance between the index and a fund, and a more technical version, which analyses standard deviations. There are so many variables that go into tracking errors today, and what we mean when we use that phrase is a fund could be closer to replicating the index than one of its peers and yet still have a higher tracking error.

As to fees, increased competition in the passive space has put downward pressure on charges as buyers have become more aware of their impact on performance. Vanguard and HSBC are among the two cheapest in the market today with 15-25bps in fees versus more expensive vehicles which charge 100bps and above. But cheap does not mean better, even in the passive space, Willcocks points out. “Why is it in every other walk of life cheap does not mean better but in financial services people expect that it is?”

The ways fees are deducted and what goes into them is important even in passive strategies. If a fund charges marginally more than a competitor but produces better returns or better replication of the market, then the question of fees becomes less important.

There has long been a debate of active versus passive but these days many agree there is a solid place for both. Investors are willing to pay more for the added alpha active managers can provide while passive strategies enable exposures to the beta of the market. Each end of this spectrum is healthy and puts pressure on the mediocrity that can exist in the middle. Willcocks is positive on the need for both but does believe consumers need a greater understanding of the risks involved in each.