Meera Hearnden: Are clients aware of the risks of passive investing?

HearndenMeera

Conventional teaching is that an index by definition should be transparent, replicable and therefore predictable, and for the major markets this tends to be the case. However, there is a potential disconnect between what investors think their passive funds do to replicate an index and the actual methodologies adopted on a day-to-day basis. This represents a risk investors may not be fully aware of.

The growth in assets among passive fund providers has been eye opening in recent years. Driven by a combination of the move to abolish revenue commissions, keener price competition among passive fund providers and the QE-fuelled markets that have supported momentum driven strategies since 2009, passive funds have collectively done well.

However, it is prudent to revisit the potent truths of these funds, which is that they not only follow the reference index on the way up but also on the way down. This was evident in the sell-off during the summer months when most major markets fell. Interestingly, active managers in the IA UK All Companies sector protected capital better than the index, as well as offering lower volatility.

Notwithstanding these points, adopting a long-term investment horizon and accepting markets tend to mean revert affords an investor to walk away from the worry of trying to identify consistent alpha generating active managers, instead relying on receiving index returns less an annual management fee by using passive funds.

This seems a sensible approach, with the investor benefiting from the pass through of lower costs, as passive fund providers avoid expensive market research, portfolio managers and risk analysis. Yet the fact indices are transparent, replicable and predictable is leading to more active elements entering into passive fund management processes than might initially be perceived to be the case – and therein lies the risk.

For example, the FTSE All Share is a well-known and commonly followed benchmark, which is highly transparent, replicable with good liquidity and offers good predictability. With this in mind, it is curious why there is such variation in returns and tracking error of passive funds that use it as their benchmark when their method of replication, we are told, is the same. The answer boils down to what they are doing given the predictability element of the index.

Given their portfolio managers know when a stock will go ex-dividend or perhaps when one will enter or fall out of the index, they move in anticipation of the event to try and capture outperformance. So long as this is done in a carefully controlled and managed way, the risk should be minimal as the standard benefits of diversification of active fund management will kick in. However, is this really what most investors think they have bought in their passive fund?

In large liquid markets the risk from such activity is relatively minor but moving into smaller less liquid markets is a different ball game. Emerging market equities, for example, is an asset class where the scope for error from such strategies meaningfully increases.

Thorough due diligence is a necessity of all funds in a portfolio regardless of whether they be active or passive. Anyone who uses passive funds should undertake regular reviews of them to keep up-to-date with the fund manager’s investment processes and seek to identify where untoward risks may lie. In doing so, investors may avoid the risk of price becoming the overriding determinant of which passive fund to invest in. Furthermore, such careful analysis can also ensure the passive funds chosen for a portfolio can deliver the appropriate risk adjusted returns in line with investors’ expectations.

Meera Hearnden is senior investment manager at Parmenion