Mind the gap
When evaluating passive investments for inclusion in client portfolios, an adviser’s due-diligence process should be every bit as thorough as it would be for active funds, says HSBC Global Asset Management
Passive funds may differ from active funds in the way they are managed, structured and traded but, among themselves, passive products from different providers can vary just as much as active funds. In order to incorporate high-quality passive funds into a portfolio, they will need to be evaluated just as thoroughly and diligently as active funds.
Even though passive investments are now an established part of an investor’s tool kit, due-diligence processes in relation to these products are still in their infancy. In the Passive Investment Client Survey, carried out by HSBC Global Asset Management last year, for example, 90% of UK wholesale investors questioned said they invest in passive investments yet 30% do not have specialised due-diligence procedures for exchange-traded funds (ETFs).
|"Fund selection based on strong risk assessment and due-diligence, rather than using a ‘default provider’, will ultimately lead to better outcomes for end-investors."
|'The rise of passive investing': For more on this subject from HSBC Global Asset Management, please click here
Lack of due-diligence may lead to elevated concentration risks of having too much exposure to a single fund provider. When asked to consider whether having a high proportion of assets invested with a single provider of passive funds posed a risk, 68% of UK intermediaries agreed – and yet, 54% of them did not impose limits on how much single exposure they may have. Of those providers that did have exposure limits to a single provider, 18% had different limits for passive fund providers compared with those for active fund providers.
As awareness of issues such as concentration risks becomes more prevalent, we expect to see better due-diligence used in the selection of passive funds. Fund selection based on strong risk assessment and due-diligence, rather than using a ‘default provider’, will ultimately lead to better outcomes for end-investors. As such, this article will cover some of the most important questions advisers should address as part of their due-diligence framework for passive fund selection.
Making the right choice
As part of passive fund selection, due-diligence is typically conducted in three stages. First, suitable indices are identified, then beta vehicles tracking them, with the final selection based on the choice of provider. The different considerations at each of these levels are weighted depending on advisers’ views on the following key factors.
* Underlying index and its coverage: Each index has its own construction methodology which determines which stocks are included from their respective investment universe. Different index providers covering the same market would not normally have the same stock selection criteria. Some equity index providers would exclude certain types of shares, while others will not or classify sectors differently from other providers. Some indices may exclude whole countries from their scope, while other providers will include them. The most commonly used index selection criteria takes into account market capitalisation of the underlying securities.
* Liquidity of the underlying market: When selecting a passive fund, investors should consider the level of liquidity – that is, availability – of the underlying index’s constituent securities. Some types of securities, such as those issued by smaller companies, may be less liquid than others.
* Physical or synthetic replication? The most straightforward way to replicate an index is physical replication. In this instance, an index fund manager purchases the underlying securities of an index. An alternative to this is synthetic replication, whereby a fund manager instead buys a swap from a third party. A swap is a derivative security providing the return from a given index in exchange for a fee and any returns on collateral held in the fund. There are concerns the risks associated with synthetic funds – the most important of which is counterparty risk – can make them a less attractive investment option as investors may not be compensated for this type of risk.
* Overall cost: When it comes to comparing fund costs, it is increasingly based on passive funds’ total cost of ownership. This way, a comparison takes into account not only management fees and the Ongoing Charges Figure (OCF), but also transaction costs.
The total cost of ownership comprises two elements. The costs of holding the fund, which are effectively reflected by the fund’s tracking difference, consists of the OCF and the costs incurred within the fund, such as rebalancing costs, taxes, dividend reinvestment/cash drag and any costs associated with the optimisation, if applicable. Meanwhile the costs of trading the fund, where applicable, include platform or brokerage transaction fees and taxes.
Tracking difference and tracking error: Passive funds’ dealing and trading fees mean they never mimic their index exactly. Two measures used to gauge this discrepancy in returns are ‘tracking difference’ and ‘tracking error’. These two measures should be considered together as tracking difference looks at how well an index is replicated over a given period of time, while tracking error, being a measure of volatility, gives an idea how consistent that replication is.
Larger providers are often able to minimise these costs through economies of scale and this factor should be considered as part of a due-diligence process. Moreover, when comparing tracking errors of different funds, investors should bear in mind that different providers may price their index funds at different times of the day. This means the figures may need to be adjusted before a fair comparison is made.
Risk management: Asset managers must be judged on their ability not only to monitor but also to control a range of risks that may affect their passive funds’ ability to track indices effectively. Risk management is a key consideration not only during portfolio construction but throughout the life of the fund.
Ongoing risk management includes the analysis of performance attributions and exposures to different parts of the underlying market. Asset managers also look at the impact of index rebalancing, currency exchange rate exposure and corporate actions, such as mergers and acquisitions, stock splits, rights issues, spin-offs or the receipt of interest and dividends.
Many fund providers use stock-lending, which helps to reduce fund costs by lending some of the portfolio holdings to a third party for a fee. It does carry some risk, however, as the stock may be lost if the counterparty goes out of business. Some providers indemnify their investors against this risk while others do not, so a review of stock-lending practices should form an important part of any due-diligence process.
Other important risk factors that asset managers always need to take into consideration are regulation and tax regimes, which may span many countries and continents, depending on the investment universe of a given fund. Changes to tax and regulation may have an impact – sometimes considerable – on the performance of the underlying funds.
Experience and brand: It may be argued that, being quantitatively-driven investment vehicles, passive funds are only as good as the processes and technology on which they are built. In addition, the track record and reputation of the fund provider also offer an effective reflection of the asset manager’s capabilities, knowledge and experience.
Independent ratings: As with active funds, there are a number of independent ratings agencies that assess passive funds’ relative performance, together with the strength and quality of their investment processes. Independent ratings are designed to help investors decide which funds have the greatest potential to deliver the best performance in the future.
This article is based on Importance of due-diligence for index tracker funds and ETFs, an HSBC Global Asset Management guide. To see the firm’s library of passive-related guides and other literature, please click here
Market risk: The value of investments and any income from them can go down as well as up, and investors may not get back the amount originally invested.
Investment horizon: Stockmarket investments should be viewed as a medium to long-term investment and should be held for at least five years.
Currency risk: Where overseas investments are held, the rate of currency exchange may cause the value of such investments to go down as well as up.
Emerging market risk: Investments in emerging markets are by their nature higher-risk and potentially more volatile than those inherent in some established markets.
Geographic risk: Some funds invest predominantly in one geographic area; therefore any decline in the economy of this area may affect the prices and value of the underlying assets.
Performance risk: Past performance is not an indication of future returns.