Meet the forgotten fund managers working for investors

Passive fund managers don't pick stocks – so what do they do all day? Rachel Rickard Straus finds out.

Picture a fund manager at work. What image pops into your head? I bet it's not too far from the one my mind conjures: someone sitting in a boardroom, quizzing chief executives and scouring through pages of company results to decide which firms to invest in.

But there is a second, quite different, group of fund managers who are often overlooked, but very valuable to investors. Many of us do not even know they exist and assume their roles are performed by algorithms – a myth that some of them find pretty hurtful.

The stereotypical fund manager is an active fund manager. He or she makes decisions, based on their expert knowledge and hunches, about what companies to invest in on behalf of their investors.

But there are also passive fund managers, whose jobs are completely different. Instead of handpicking companies to invest in, they oversee the purchase of some of all the shares in their chosen index, hoping that on balance the value of the shares will rise over time. So, for example, a fund that tracks the FTSE 100 index – which is a list of the 100 biggest companies listed on the London Stock Exchange – will buy shares in every company in the FTSE 100.

It's easy to see why people mistakenly think passive funds are run purely by computers and algorithms, rather than overseen by fund managers.

Firstly, passive - also known as index - funds often have hundreds, thousands or even tens of thousands of shares and bonds in different companies. Surely a human couldn't oversee a portfolio that big – or so we might think.

Secondly, passive funds are much cheaper than active ones. We're told that this is because you're not paying for experts to pick your shares. However, this doesn't mean that passive funds don't use human expertise at all.

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There will never be a star passive fund manager, and they will never outperform the market. But nonetheless these experts do an essential job and some are improving the industry for all investors.

I decided to visit the trading floor of the Vanguard LifeStrategy funds to experience a day in the life of passive fund managers. Here, over a trillion dollars' worth of shares were traded last year alone.

It's a bustling Thursday morning, and fund managers and analysts are sitting at desks with several monitors each, or debating in meetings or catching up with the risk management team. I can confirm, they are definitely not robots.

In a boardroom with beautiful views across London's Square Mile, I speak to Mark Fitzgerald, head of ETF [exchange-traded fund] product management, Europe.

"People often make the mistake of thinking passive funds are run by computers," he says. "The number of times I've heard that – I was a fund manager at BlackRock and BGI [Barclays Global Investors] running a lot of these different strategies and it used to annoy me intensely because you need portfolio managers [another term for passive fund managers]."

Mark says that when trying to understand the role of passive fund managers, "the simplest analogy is that of an airline pilot".

He explains: "On a plane, you've got massively complicated technology that people don't even think about. They don't give a second thought to the components in a plane, but you're very relieved as a passenger when the guy or the woman comes out of the cockpit with the hat and stripes and they look very official. You give a sigh of relief – 'there's the person in charge, I can relax now'.

"In passive funds, you take the technology – like the aeroplane – and then you have experienced individuals who are well qualified to oversee this process."

Algorithms can do a lot of the work, however, there is no technology currently available that can do it all automatically, which is where human expertise comes in.

Mark explains: "On any given day, if you've got 6,000 securities [shares and bonds], there will be dividends being paid, there will be companies being taken over, there will be companies coming in and out of the index, there will be companies doing stock splits creating more shares or rights issues, there will be voting going on.

"There will be all of this activity and no one's yet been able to build a sophisticated enough algorithm to account for all of these things."

Mark adds that when financial markets are affected by an event such as a political coup, fund managers can talk to brokers and people on the ground and colleagues across the globe to work out what's going on and how to respond.

One of the reasons that passive funds are popular with investors is because they know exactly what they're buying – it should do exactly what it says on the tin.

If a fund tracks the FTSE 100, for example, we expect that it will produce exactly the same return as the FTSE 100. As markets move up and down and investors add or remove money from the fund, there is a lot to do to maintain the balance.

Vernita Exum, head of equity index portfolio management, Europe (pictured above), heads up a team that buys and sells shares – also known as equities – for the Vanguard LifeStrategy funds.

The LifeStrategy funds are five ready-made portfolios, each containing between 6,000 and 20,000 shares and bonds of companies around the globe.

Every day, investors add money to the funds or take money out. It is up to Vernita and her team to make sure the new cash coming in is invested, without upsetting the balance.

"We have an amount coming in every day," she explains. "It can fluctuate greatly over the day from £25 million and up across all the funds to – if it's a light day – no flows. We tend to see more consistent flows across all funds at month-end when people tend to put a little bit of extra money to work."

Some indices have tens of thousands of holdings and it's simply not possible to buy all of them. A good passive fund manager will have to choose which to buy to track the index as closely as possible.

This is especially true of passive bond fund managers. Some bonds are hard to buy and may not even trade from one month to the next. No algorithm could go out and find them all. That's where fund managers may have to use their trading contacts and relationships to source them or use their expertise to decide which they can drop while still tracking the index.

Chris Wrazen, Vanguard's head of bond indexing, Europe, explains: "It's quite a bit different than people think. I always like to say that fixed income index [passive bond fund management] is a very active process – you don't think of it that way, but it is."

He explains that since it's impossible to buy all the bonds in some indices, they will try to replicate them in other ways so the effect for investors is the same.

He says: "We employ a stratified sampling strategy where we'll match certain risk factors. So rather than matching line by line at a security level, there are certain targets that we're trying to hit from a credit quality standpoint, on a sector level, credit quality or currency – all these we manage to track relative to the benchmark."

Good bond fund managers may also be able to drive down costs. One company will often issue lots of different types of bonds. A quality manager can use their expertise to pick the ones that will get the best returns for investors, without taking on too much risk.

Chris says: "Our number one mandate is tracking – it's about 75% of what we focus on and then the other 25% is that small alpha component [making money]. We're not shooting for 50 basis points [0.5%], but if you can add two to three basis points [0.02% or 0.03%] and that cuts a quarter of the expense ratio, that would be a good outcome."

So how can you spot a good passive fund?

A successful active fund will perform above its benchmark. A good passive fund should do no better or no worse. The closer a passive fund tracks its index, the better its strategy is likely to be. In fact, if a passive fund outperforms, its managers can be penalised.

A passive fund may not be able to produce better returns than the index it's tracking, but it can use some of its additional gains to drive down fees for investors, as Chris describes.

A good fund manager may also get stuck into changing the overall landscape for investors.

For example, companies listed in Saudi Arabia were recently introduced into the global indices that some passive funds track. Before this happened, Vanguard specialists met with the regulators to give recommendations on what needed to happen to make it work for investors.

"Trading a new market is a highly debated topic across all regions and we pull in all the portfolio manager expertise across the globe to determine what the strategy should be," says Vernita. "The discussion is led by my team and expert portfolio manager, who took a trip to Saudi Arabia to meet the sovereign funds, the regulators and the exchanges to do high-level research to make sure that we can help influence how investible that market is."

A passive fund manager will never become a household name, but they can help drive down costs for investors, offer exposure to thousands of companies at very low cost and help to transform the industry for the better.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.