Passive investing: three rules to invest in tracker funds and ETFs

Passive funds require less due diligence than active funds, but don't skimp on the research, writes Jennifer Hill.

Over the past decade, passive investing has soared in popularity. There are two main reasons for this. First, index funds and exchange traded funds (ETFs) have been aggressively cutting their fees. Investors can now pay less than 0.1% to track the fortunes of developed markets such those in the UK and the US.

Second, scepticism is growing about the ability of active fund managers to consistently add value through stockpicking. Wherever you stand on the active versus passive argument, and indeed if you sit on the fence, it is vital to do your homework.

Below are three essential pointers to digest that should keep you on the right track when taking on passive investments.

Don't assume all indices for a region are the same

Regional indices don't necessarily perform in line with each other. Two investors tracking the same market but in different regional indices might end up with significantly different returns. Why so? Chief among the reasons are differences in the way indices are constructed.

The emerging markets sector provides a stark example of a sector where regional indices that ostensibly cover the same sector can diverge. Ian Aylward, head of manager and fund selection at Barclays Wealth & Investment Management, says:

"An entire country – South Korea, at a 15% weighting – is included in MSCI's [emerging markets sector] but excluded from the FTSE's." 

That's because MSCI regards South Korea and Poland as emerging markets, while the FTSE categorises these markets as developed. As a result, FTSE emerging markets indices have less exposure to technology firms such as Samsung (LSE:SMSN).

Differential exposure to a range factors is another key reason for misalignments. Christopher Gannatti, head of research at WisdomTree, points to five factors that tend to be responsible for differences in performance: momentum, low volatility, value, quality and size.

"Even if two indices are both exposed to, say, 'broad Europe', they may have different methodologies and, ultimately different exposures to these factors," he says. If, for example, growth is in favour and value lags (as has been the case in recent years), strategies that tend to be more value-focused will underperform those that have a greater emphasis on quality (see bottom chart opposite).

In addition, differences in the performance of two ETFs that follow the same index can arise from a disparity in how closely they track their specific regional index. Mark Fitzgerald, head of ETF product management for Europe at Vanguard, says:

"Index-tracking fund providers manage index funds in different ways. We encourage investors to understand the manager’s investment process and check the tracking error of an index-tracking fund to ensure it is delivering as close to the index return as is possible." 

The lower the tracking error, the more faithfully a passive fund is matching its index.

Fees have a big effect on a fund's tracking error. Peter Sleep, a senior investment manager at Seven Investment Management, says: "Often the biggest factor is fees, reinforcing the need to keep costs low."

Rule of thumb: tracking error is a valuable guide to accuracy and value.

Be wary of synthetic ETFs

Unlike a physical ETF, which will actually hold an asset, a synthetic ETF simply tracks the asset. The ETF issuer enters into a swap contract with a counterparty to provide a return equivalent to that from the underlying asset. With this comes what is known as counter-party risk. Aylward says: "The risk is that the counterparty with whom the ETF has a performance swap goes bust. This has happened – think Lehman Brothers."

However, Jose Garcia Zarate, associate director of passive strategies, manager research, at Morningstar, says the risk attached to synthetic replication has been hugely mitigated over the past decade. For one thing, synthetic ETFs now have multiple counterparties. He adds:

"ETF providers that offer synthetic ETFs have put in place a series of safety measures to protect investors, although this makes explaining how synthetic ETFs work more difficult."

Most investors prefer the simplicity of physical replication, says Fitzgerald. "Physical ETFs are generally more transparent, straightforward and easy to understand. In our experience, retail investors value that certainty and security."

However, while Sleep acknowledges the risk of synthetic replication, he says he "would not want to overstate it". There are advantages to synthetic ETFs: accuracy in matching underlying asset returns; the possibility of generating superior returns due to efficiencies arising from market access, tax and trading scale; and access to exposures that cannot be reached through physical ETFs. These include short and leveraged products, volatility indices, some emerging market securities and non-metal commodities.

Note that some physical ETFs lend their holdings to generate extra revenue. That exposes investors to counterparty risk, as the borrower of a security might fail to return it, albeit safety measures have been put in place to protect investors against this.

Zarate says:

"The bottom line is: do your research. If you don’t understand how an ETF works or you are uncomfortable with the risks, don’t invest in it."

Rule of thumb: ETFs and passive funds as a whole come with type-specific risks.

How factors affect performance when investing in European equities

Notes: Annual returns over one year to 27 August 2019, net of foreign tax withholdings on dividend payments in dollar currency terms. Value refers to the MSCI Europe Enhanced Value index. Size refers to the MSCI Europe Risk-Weighted index. Europe refers to the MSCI Europe index. Momentum refers to the MSCI Europe Momentum index. Minimum volatility refers to the MSCI Europe Minimum Volatility index. Quality refers to the MSCI Europe Quality index. Source: MSCI

Not all passives are low cost

The key selling point of passive funds is low costs. A race to the bottom over the past decade means most funds are competitively priced. Sleep says: “For the major indices such as the FTSE 100 and S&P 500, or a gilt fund, you should not be paying more than 0.25% a year and ideally less than 0.1%.”

Some older passive funds charge far in excess of this, however. "If you are invested in Halifax or Virgin FTSE 100 trackers ripping you off by charging up to 1% a year, get out," says Zarate.

Scottish Widows has a UK tracker that charges 1%, while an old share class of L&G Tracker Trust CTF, which follows the FTSE All-Share index and has nearly £200 million invested, charges 1.5% – about £3 million a year in fees.

Cost significantly affects performance. Vanguard data shows that a £10,000 investment in a UK index fund that returns 5% for 20 years would deliver a return of £26,010 if the fund’s fee is 0.1% but just £21,739 if it is 1% – £4,271 less (see chart).

You can track a mainstream equity index for a fee of less than 0.1%, but expect to pay more for exposure to niche areas. "The more diverse the index or the more niche its asset classes, the more expensive it is to track," says Aylward. "An emerging market bond tracker, for example, has to hold thousands of lines, while a high-yield bond tracker is more niche and relatively illiquid, so their costs are relatively high. Overall, expect to pay as little as 0.2% and no more than 0.4%."

Rule of thumb: never pay over the odds for any passive fund.

Fees erode returns over the long term