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An introduction to passive investment

Passives logoPassive investments - active decisions

When it comes to making appropriate fund selections, passive investments – despite their name – demand a good deal of active decision-making. This burgeoning sector of investment contains a wide range of different styles and approaches, each of which can bring something different to a portfolio. That being so, what are the key decisions anyone planning to use passive funds needs to consider?

* Index or non-index?

Index funds are the best-known and most common form of passive investment but other types do exist. As the name suggests, index funds track the performance of a particular market index, which may be done in a number of ways – most obviously by owning the same stocks in the same proportions as they are in that index.

"These days there is far greater choice among passive funds – and thus far greater need to think carefully before making a selection."

Indices can be market capitalisation-weighted, such as the FTSE 100 in the UK or the S&P 500 in the US, or ‘factor’ weighted, such as the S&P 500 Dividend Aristocrats, which weights individual stocks on the basis of their dividend yield. For their part, non-index passive funds will operate a set of criteria on which stocks are automatically bought and, if they no longer meet those criteria, sold.

* Which index?

The question of which index to track has become increasingly important over the last few years. In the past, passive funds tended to confine themselves to the major indices, such as the MSCI World or the DJ Eurostoxx, but there is now far greater choice – and thus far greater need to think carefully before making a selection.

Every index will have its inherent biases. The FTSE 100, for example, has a relatively high weighting in mining and commodities stocks while the MSCI World is almost 60% weighted to the US. Meanwhile market capitalisation-weighted indices will be dominated by the global behemoths, such as banks and pharmaceuticals. None of these biases are a problem in themselves, but investors and their advisers do need to be aware of how they may shape or affect the portfolio they are building.

* Which replication strategy?

Index funds adopt a number of different strategies to replicate their underlying index. Some use ‘physical’ replication, which involves buying the underlying stocks in the exact proportions in which they appear in the index. These weightings would then be revisited whenever the index is rebalanced. 

This can be appropriate when the stocks involved are large and liquid. However, when trying to replicate an index of smaller companies, for example, or emerging market stocks, where liquidity may be thin and trading infrequent, physical replication can be difficult and may add cost.

In this case, passive managers tend to employ a ‘sampling’ strategy. This involves taking a representative sample of securities from the underlying index. If, for example, the index held 10% in healthcare stocks across 20 companies, the ‘sample’ might include a similar weighting, but would not hold all 20.

The alternative to the physical replication of an index is synthetic replication. Here, the fund manager buys a derivative – usually from an investment bank – that guarantees it will pay out the index return. These funds must hold collateral to ensure investors are protected if the investment bank goes bust. However, the collateral may not exactly match the stocks held in the index so investors may see a different return from the one they were expecting.

Regardless of the index a passive fund tries to replicate and how it sets about doing so, there will always be some difference between the performance of the fund and its underlying index. In absolute terms, this is known as ‘tracking difference’ or, if it is measured over a period of time, as ‘tracking error’.

* Which structure?

Passive investments may be structured in a variety of ways – as exchange-traded funds or as open-ended or closed-ended vehicles.

Exchange-traded funds (ETFs): Originating in the US in 1993, ETFs have since seen significant growth across the world. They are open-ended, which means investors can buy into or sell out of them at any point and their price directly reflects the underlying value of the investments they hold.

ETFs differ from other structures in that they are listed on a stock exchange, like shares, and thus may be traded at any time the market is open. Investors may buy and sell as little or as much as they like at any point during the trading day. This also means the price fluctuates throughout the day in line with the underlying index.

ETFs can track indices relating to a wide range of different assets, including equities, bonds, commodities and currencies. They may use synthetic or physical replication methods and can also incorporate leverage – in other words, borrow to invest. 

Mutual funds: Open-ended passive funds first appeared in the 1920s and now make up around 10% of the UK open-ended fund market. Their popularity has recently been increasing as groups such as US giant Vanguard have entered the market.

As with all open-ended funds, they have to create and redeem units as investors buy and sell, which means they only price once a day. For longer-term investors, this may be less of a consideration, but it may influence those with a shorter time horizon. Mutual funds may also operate higher minimum investment levels. 

Investment trusts: The original tracker vehicles, passive investment trusts are now relatively rare. They may be bought and sold in the same way as a conventional stock and can trade at a discount or a premium to their underlying assets. 

As the passive investment sector becomes ever more diverse, investors will be able to use these funds to build increasingly nuanced portfolios. They should not, however, be seduced into thinking that passive investment is the ‘simple’ choice – as with all investment, there are active decisions to be made.

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