Not all passive managers are equivalent

Published by Gaurav Gupta on

Estimated reading time: 7 minutes


Investors are often nonchalant about the selection of their passive managers, on the basis that the performance will be the same regardless of which manager they chose. However, there are a number of ways in which a passive manager is able to add value to investors and reduce the burden of fees on performance and, by investing in the right fund’s legal structure, unnecessary taxes may be avoided.

1.    Reducing the fee burden

Tracking method

There are three common methods used to passively track an index which can each lead to different performance results:

  1. Full replication – Funds that hold every stock in their index at the corresponding weight. This approach may mean performance closely matches the index gross of fees, but can be expensive for some asset classes
  2. Partial replication – Funds sample a portion of their benchmark’s securities, often because the cost of holding all securities in the benchmark would be high or impractical
  3. Derivatives – Funds use swap-based contracts to ensure they match their indices’ performance or futures contracts

For equity funds, the most common and popular approach is a fully replicated method as the fund holds the same stocks as the index with only small differences in weightings and how dividends are treated. Fixed Income passive funds most commonly use partial replication, as buying and holding all the bonds in the index can be difficult and less liquid, given bonds are not traded using an exchange.

Active input

In addition, there are active methods passive asset managers employ to offset the impact of fees or even boost performance versus the index over time. We have set out some of the more common methods used by passive managers below. 

This involves the passive fund transferring equities or bonds temporarily to a borrower. In return, the borrower transfers other shares, bonds or cash to the lender as collateral and pays a borrowing fee. The profits (if the borrower does not default) minus any fees and asset manager commissions, are added back into the fund for the investors’ benefit.

Some managers try to predict which stocks will be added or removed from an index so they can make the changes to their portfolio “early”, before it is reflected in the index. This is a race versus other investors, as they all aim to benefit from the subsequent boost or decline in price upon the addition or removal of the stock from the index (as all the other passive funds are forced to buy or sell the stock). A similar, but less risky, approach is to come up with a trading strategy for adding/removing a stock when a company has already been confirmed as due to enter or exit the index by the index provider. For fixed income funds, they may gain an advantage by purchasing newly issued bonds they believe will be included into the index at a later date.

Larger providers have built up internal trade networks that eliminate the trading costs incurred when purchasing stocks on the open market; these providers aim to move stocks between funds internally before going to open market.

To maintain liquidity in the portfolio, the manager may need to hold cash or liquid securities. However, some may decide to hold futures on the market instead of cash, meaning that a greater proportion of assets is continuously invested in the market.

Rather than holding all of the index constituents, optimisation involves holding a basket of stocks or bonds, such that the overall portfolio broadly matches the characteristics of the index. If, by doing this, a fund can avoid frequently trading stocks or bonds or trading trivial amounts without this being detrimental to the performance of the fund. They can then avoid the costs associated with those trades and the drag this has on performance.

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This involves taking active decisions on the underlying holdings before optimising the portfolio to match the characteristics of the index. For example, in fixed income some passive managers actively select corporate bonds and then optimise the portfolio to match the index characteristics in hopes of slightly better performance.

Whilst each method can aid performance and help reduce the “fee drag”, it is important to highlight that there are associated risks. In particular, the sample of bonds selected under the optimisation methods can lead to large differences in performance, both negatively and positively.

“Fee drag” example
A 0.10% annual management charge applied over the past five years for the FTSE All World (as the end of 2019), leads to an underperformance of 0.81%.

Investors therefore have to decide which approach to passive investing is most in line with their performance expectations. For example, investing into a passive fund that aggressively tries to add value using stock lending, or forecasting index constituent changes, may lead to slightly larger differences in performance versus the index in the short-term (positively or negatively), but hopefully closer to index performance net of fees over the long-term.

On the other hand, investing into a more simply run passive fund will mean fees and other costs (such as transaction costs) will have a bigger negative impact on performance over the long-term, and less impact in the short- term.

Other important factors

The following factors also impact performance:

  • The size of the fund – Especially in physically replicated funds, the size of the funds determines its ability to hold all of the stocks in the index, in the right proportions. Smaller funds may struggle, for example, to hold all 1600+ stocks in the MSCI World Index, leading to larger tracking errors than larger funds who are able to do this. In addition, larger funds benefit from economies of scale, including potentially lower trading costs.
  • Time – Where funds use optimisation methods (mostly fixed income funds), the longer the fund has been up and running, the longer they have had to develop their optimisation methods so they match the index characteristics, and to find and buy the “right” securities in the market.

Therefore, it is not surprising then that the largest funds with the longest track record continue to attract new investors. The passive market is much more concentrated than the active market, with only a handful of asset managers offering a good selection of products – this is because scale is required to make the funds successful and profitable for the firm at the low fees charged.

Impact of legal structure

Depending on the client type, investing into the right legal structure can make a big difference. For example, UK pension funds may be subject to lower withholding tax rates on overseas dividends than UK authorised funds. However, unless an authorised fund is structured specifically as a tax transparent fund, pension investors in the fund will not be able to claim the reduced rate. 

It is worth mentioning that index funds are typically preferred to exchange traded funds (ETFs), as they are typically easier to invest into – avoiding broker and custodian arrangement and fees – and they are priced at NAV, avoiding premium and discount risk associated with ETFs. The disadvantage of an index fund is that they can only be traded once a day versus an ETF that can be traded throughout the day which is a feature that not many UK pension schemes need.

Checklist for passive investing

When selecting a passive manager, there are a number of considerations investors should take into account to ensure the performance will be as expected and that you are getting the best deal. 

  • Appropriate tracking method 
  • Possible impact of active input
  • Large and long-running fund
  • Suitable legal structure

Your managers’ approaches to the above could have a notable impact on long-term performance. If you’d like to discuss this in relation to your institution’s investments, please get in touch with your usual Barnett Waddingham contact.