Making a decision to simply ‘buy the market’ via an Index Tracker Fund or an Exchange Traded Fund (ETF) is not as simple as you might expect.
An index tracker fund is a type of mutual fund with a portfolio constructed to match or track the components of a specific market index, for example the FTSE 100 Index.
An ETF, on the other hand, is a marketable security that tracks an index/a commodity/bonds or a basket of assets like an index tracker fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold.
Like actively-managed funds, passive funds have their intricacies so it is important to look under the bonnet to ensure you understand what you are buying.
Here are a few pointers to help with the process:
Fund or ETF?
In a particular quarter or year, passives will not completely replicate the performance of an index. This is down to the fact that they have different costs and structures, and are priced at different times of the day, so you can expect some degree of performance drift. An ETF is a listed security that can be traded through the day. In contrast, an index tracker is a mutual fund that is priced once a day, normally at noon. Fees can differ among providers.
What Is Being Tracked?
When investing in a collection of markets, it is important to understand how the different exposures break down and be able to identify what is actually being tracked.
This is especially true for Emerging markets and Asia-focused ETFs or index trackers, offering exposure to broad regions. The breakdown of how much is allocated to each country can vary from product to product, so it is important to make sure that the underlying exposures are appropriate and acceptable.
In addition, it is worthwhile confirming how often the portfolio is rebalanced to ensure that it does not drift too far away from the index. Tracking bond markets passively can also prove challenging.
If the aim is simply to track a bond index via a mainstream market cap-weighted product, the highest allocations will be to those countries and companies with the greatest amount of debt issuance. This may not necessarily be a sensible decision. In the high yield asset class, the performance of the passive offerings has diverged significantly from the index at times.
How Does It Work?
It is important to distinguish whether a fund or ETF is physically backed by the underlying index it is tracking, or replicates the index using ‘synthetics’: If it takes the physical route it means the fund buys all (or most) of the underlying shares in the index.
Synthetic replication works completely differently in so far as you are effectively buying a contract with a third party, normally an investment bank, to provide you with the same return offered by the index. The third party does not need to hold all of the shares within the index, but they should hold some collateral. This can be in the form of shares, although these may not necessarily be in line with the index you are seeking to track. It is important to monitor what shares are held.
Decision Need Not Be Binary
The passive market has grown exponentially over the past decade and in recent years, many investment columns have been devoted to the so-called ‘active versus passive’ debate.
Those in favour of actively-managed funds highlight that fund managers can take advantage of investment opportunities as they arise, in addition to those created by market volatility.
In contrast, they claim passive funds have little flexibility to ‘swim against the tide’ and therefore guarantee underperformance (after fees). The passive cohort, however, highlight the reams of academic studies that show a large portion of active managers underperform the market and there is the perennial question of fees.
In our opinion, it is not about choosing one side over the other. We believe the active versus passive debate is outdated because it is not a binary decision to invest in an actively-managed fund over a tracker fund, or vice versa.
For us, it is simply about selecting the most appropriate investment vehicle that will achieve the best outcome for our clients. Initially, we make an asset allocation decision such as increasing exposure to a specific part of the market because it looks attractive. We then assess both the active and passive opportunities and carefully analyse the most suitable one for the client depending on their risk profile and objectives.
This article was adapted from “Active versus passive investing: the decision is not binary” (Dialogue, Autumn 2016) by Alex Baily, Portfolio Director, Cazenove Capital Management.
This document is issued by Cazenove Capital Management Asia Limited (“Cazenove Capital Management Asia”) of Level 33, Two Pacific Place, 88 Queensway, Hong Kong, who provide discretionary investment management services. Cazenove Capital Management Asia is licensed and regulated by the Securities and Futures Commission. This document is intended to be for information purposes only. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.