Evaluating Open-Ended Passive Funds
In theory, selecting passive funds for investment should be quite straightforward. This is certainly true when compared to the work required to identify suitable active funds but still challenges remain. The range of options for passive investment has broadened enormously over recent years as the ETF industry has developed and if systematic smart beta options are included, the options become boggling. During the summer, Square Mile initiated a ratings coverage of passive funds. This article highlights some of the issues that we came across in analysing passives and how we set about overcoming some of these difficulties.
Firstly, we restricted ourselves to mainstream open ended vehicles. There are well over 1,000 listed ETFs available to investors with many following a smart beta approach. However, there are questions as to whether smart beta approaches should be considered passive or active management. For instance, value indices can be defined by a price to book, price to earnings, price to cash flow or through a combination of these factors. Since a subjective judgement is required to identify the most appropriate metric I believe that smart beta approaches require a due diligence approach more in keeping with active funds and were excluded from our review of passive funds.
As it happens, most flows go into the more traditional market cap weighted based index funds. By restricting our research to passives tracking the main broad equity and gilt bond indices, it circumvents the imponderables caused by liquidity. Many indices were not designed to be traded and problems can arise from time to time (often at the most inopportune moments) where a mismatch occurs between the liquidity offered by a fund and the underlying securities in the index.
While it generally holds that past performance is no guide to future performance for active funds, the situation may be different for passive funds. After all, it would be a great surprise if fee levels were not a major determinant of relative performance for passive funds. In the UK, a price war has sent management charges spiralling lower over recent years. This has clouded the importance of performance records of the index funds. A fund with a 10bps fee can still have a lousy performance record if last year it was charging 100bps. We felt the most appropriate way to analyse the funds' track records was to consider gross performance data and then adjust with the current fee schedule. Our analysis revealed that while the cheapest funds were not necessarily the best, cost is certainly one of the more important factors to consider.
A further complication is caused by the mismatch of the fund pricing time (often midday) and the index pricing time at the close of business. This is an issue that affects many active funds as well, for example the IA North American sector tends to outperform during months when the S&P 500 slumps on the final trading day of the month. Of course, what is gained in one month is recouped in the following month but the distortion can catch out the unwary. BlackRock have recently changed the benchmarks on some of their passive funds so that the index price is taken at same time as the fund is priced. Our solution to the issue was to avoid taking data snapshots and to look at performance over multiple rolling periods. Our analysis was primarily focused on daily annual returns over a five year period. However, such is the volatility in equity markets, especially during the euro crisis during 2011/12, that even these charts are too choppy to allow easy analysis, as the chart demonstrates. This problem was overcome by applying a 30 day moving average to further smooth out the chart and reveal the trend in tracking difference.
One surprise that our work uncovered was the lack of impact that stock lending activity had performance. A number of firms have a policy of not lending stock to avoid introducing any counterparty risks to their funds. Of the firms that do stock lend, Square Mile ratings were only assigned to firms that had policies in place to ensure that the the fund was protected in the event of a counterparty default. However, when stock lending was undertaken, typically only a small proportion of the fund's holdings were out on loan and the fees generated were generally limited. Curiously, the more lucrative situations were found in Europe, since opportunities exist for dividend withholding tax arbitrage.
While fees are an important factor in selection of passive vehicle, consideration should also be given to other factors highlighted in this article. Our review of the sector confirmed that the ranges supplied by BlackRock, Legal & General Investment Management and Vanguard were of excellent quality. However, the ranges supplied by lesser known passive providers such as Fidelity, HSBC and Royal London are also very worthy of consideration as potential options.
Firstly, we restricted ourselves to mainstream open ended vehicles. There are well over 1,000 listed ETFs available to investors with many following a smart beta approach. However, there are questions as to whether smart beta approaches should be considered passive or active management. For instance, value indices can be defined by a price to book, price to earnings, price to cash flow or through a combination of these factors. Since a subjective judgement is required to identify the most appropriate metric I believe that smart beta approaches require a due diligence approach more in keeping with active funds and were excluded from our review of passive funds.
As it happens, most flows go into the more traditional market cap weighted based index funds. By restricting our research to passives tracking the main broad equity and gilt bond indices, it circumvents the imponderables caused by liquidity. Many indices were not designed to be traded and problems can arise from time to time (often at the most inopportune moments) where a mismatch occurs between the liquidity offered by a fund and the underlying securities in the index.
While it generally holds that past performance is no guide to future performance for active funds, the situation may be different for passive funds. After all, it would be a great surprise if fee levels were not a major determinant of relative performance for passive funds. In the UK, a price war has sent management charges spiralling lower over recent years. This has clouded the importance of performance records of the index funds. A fund with a 10bps fee can still have a lousy performance record if last year it was charging 100bps. We felt the most appropriate way to analyse the funds' track records was to consider gross performance data and then adjust with the current fee schedule. Our analysis revealed that while the cheapest funds were not necessarily the best, cost is certainly one of the more important factors to consider.
A further complication is caused by the mismatch of the fund pricing time (often midday) and the index pricing time at the close of business. This is an issue that affects many active funds as well, for example the IA North American sector tends to outperform during months when the S&P 500 slumps on the final trading day of the month. Of course, what is gained in one month is recouped in the following month but the distortion can catch out the unwary. BlackRock have recently changed the benchmarks on some of their passive funds so that the index price is taken at same time as the fund is priced. Our solution to the issue was to avoid taking data snapshots and to look at performance over multiple rolling periods. Our analysis was primarily focused on daily annual returns over a five year period. However, such is the volatility in equity markets, especially during the euro crisis during 2011/12, that even these charts are too choppy to allow easy analysis, as the chart demonstrates. This problem was overcome by applying a 30 day moving average to further smooth out the chart and reveal the trend in tracking difference.
One surprise that our work uncovered was the lack of impact that stock lending activity had performance. A number of firms have a policy of not lending stock to avoid introducing any counterparty risks to their funds. Of the firms that do stock lend, Square Mile ratings were only assigned to firms that had policies in place to ensure that the the fund was protected in the event of a counterparty default. However, when stock lending was undertaken, typically only a small proportion of the fund's holdings were out on loan and the fees generated were generally limited. Curiously, the more lucrative situations were found in Europe, since opportunities exist for dividend withholding tax arbitrage.
While fees are an important factor in selection of passive vehicle, consideration should also be given to other factors highlighted in this article. Our review of the sector confirmed that the ranges supplied by BlackRock, Legal & General Investment Management and Vanguard were of excellent quality. However, the ranges supplied by lesser known passive providers such as Fidelity, HSBC and Royal London are also very worthy of consideration as potential options.