Halifax UK FTSE All Share Index Tracker, L&G UK Index and iShares Core MSCI Japan IMI UCITS ETF are among the multi-billion pound passives that have received FE’s worst Passive Crown rating, as a result of high tracking difference and tracking error. 
One of the major misconceptions in the active versus passive debate is that because the average active fund fails to beat its benchmark in many cases, investors should just use low-cost tracker funds or ETFs which give them automatic index performance.
Markuz Jaffe, fund analyst at FE Research, points out that tracker funds and exchange traded funds (ETFs) are by no means born equal. While they all attempt to replicate an underlying index, some have been much more successful than others over the years. He says there are a number of reasons for this.
“It really comes down to the replication method and how they are trying to minimise costs,” Jaffe said.
“In terms of the replication method, it depends on whether the fund uses synthetic or physical replication. For example, it makes sense to use physical replication to track the FTSE 100 in order to minimise trading. However, if you are a tracking a bond index, it’s difficult to efficiently buy all the bonds out there so it makes sense to use a sampled physical or synthetic replication approach. These decisions will then impact on the fund’s tracking difference and error.”
“Overlaying on top of everything, though, are costs and how the management fee is charged, whether they try to offset these fees by use of stock lending or a strategic partnership with a derivative provider.”
He added: “These all culminate in what the end investors see in terms of their return.”
Jaffe’s point is emphasised by a recent study carried out by FE. Our research found that 55 per cent of actively managed UK All Companies fund that use either the FTSE All Share or sector average as their benchmark have outperformed the All Share over an eight year period, whereas 70 per cent have beaten the average tracker.
Performance of average UK growth fund, average FTSE tracker and index over 8yrs
Source: FE Analytics
To help advisers and investors distinguish between the huge range of passive vehicles, FE today launched the FE Passive Fund Rating, which measure funds and ETFs principally on their ability to minimise tracking error and tracking difference.
The ratings system, which judges passives principally on tracking difference and tracking error, reviews more than 250 ETFs and passive funds. The full methodology of the rating is featured here. We have also launched a dedicated Passives Funds section on the site that allows advisers and investors to filter out passive funds in a number of different ways, including by FE rating.
Earlier in the day we highlighted a selection of the passives that have the maximum number of Passive Crowns. Here we take a closer look at five of the tracker funds and ETFs that have been handed FE’s lowest passive rating, proving that not all passives are born equal.
These are by no means the only funds that have achieved one Passive Crown of course, but are merely some of the examples with the largest volume of assets under management.
Halifax UK FTSE All Share Index Tracking
First up is the Halifax UK FTSE All Share Tracking fund, which is one of the UK’s largest trackers with £2.3bn under management.
The fund scores full marks for liquidity, but the fund hasn’t been able to match the returns of its FTSE All Share benchmark. In fact, they haven’t even come close, particularly over the longer-term.
According to FE Analytics, if investors had bought into the fund 10 years ago they would have since seen a return of 88.65 per cent. However, its benchmark has gained 123.19 per cent meaning Halifax UK FTSE All Share Index Tracking fund has had a sizeable tracking difference of 34.54 percentage points over that time.
Performance of fund versus index over 10yrs
Source: FE Analytics
Its tracking error, which represents the divergence between the price behaviour of a portfolio and the price behaviour of a benchmark, has been 7.17 per cent over the period in question. Its tracking error is above 5 per cent over one, three and five years as well.
The L&G UK Index fund also aims to mirror the FTSE All Share’s returns and also has just one FE Crown.
The tracker is more than double the size of the Halifax vehicle at £4.9bn. While it hasn’t performed as badly as its counterpart, it’s still fallen well short over the long-term.
Our data shows it has a tracking difference of 11.82 percentage points and a tracking error of more than 8 per cent, relative to the FTSE All Share, over 10 years. While its tracking difference is lower over shorter time frames, its tracking error is still wide over most periods.
A spokesperson for L&G says steps have been taken to improve performance. They say the share class used in the figures above is no-longer sold for new business into the intermediary market following the retail distribution review (RDR).
“The ‘I’ class of the L&G UK Index fund is available on all major platforms, and reflects the ‘post-RDR’ fund,” the spokesperson said.
L&G UK Index’s new I share class has an ongoing charges figure (OCF) of 0.1 per cent. The much older and larger ‘R’ share class has charges of 0.56 per cent – very high considering investors are able to get exposure to Neil Woodford’s CF Woodford Equity Income fund for 0.6 per cent on certain platforms.
Virgin UK Index Tracking
Another multi-billion fund to feature on the list of one Passive Crown-passives is Virgin UK Index Tracking.
The Virgin fund – which is £2.6bn in size and overseen by State Street Global Advisors – has a relatively low tracking error of below 3 per cent over 10 years. The fund’s unit price has closely matched the price of its benchmark, the FTSE All Share, over that time but in total return terms the fund has delivered substantially less than the index, as the graph below shows.
Price and total return performance of fund versus index over 10yrs
Source: FE Analytics
The Virgin fund is one of the most expensive trackers on the market, charging an OCF of 1 per cent.
“Virgin Money's fund uses a full replication methodology, rather than the partial replication that some funds adopt, in order to replicate index movements as closely as possible,” a spokesperson for Virgin said.
“The reason for the difference in total returns over a 10 year period is the annual management charge. Virgin Money is committed to a clear and transparent approach to charging and has a single fee.”
“We are proud to be able to give customers, including smaller investors, access to the FTSE All Share Index at any level of investment.”
The final UK fund we highlight is the £427m Scottish Widows UK Tracker.
The fund has returned 20 percentage points less than its FTSE 100 benchmark over the past 10 years and close to 10 percentage points less over five years. Its tracking error has also been very high.
Over one, three and five years its tracking error is above 8 per cent while over the last decade it is in double-digit territory. Its poor performance could largely be down to the fact that its OCF, at 1 per cent, is much higher than average.
Speaking for both the Halifax UK FTSE All Share Tracker and the Scottish Widows UK Tracker, a spokesperson for Lloyds Banking Group said there a number of reasons for the two portfolios' poor performance.
“The Halifax UK FTSE All Share Tracker and the Scottish Widows UK Tracker funds have been successful in tracking the index with a low tracking error," the spokesperson said.
“The divergence in performance relates to the charge on the selected share class. Since October 2009, this charge has been no more than 1 per cent on any share class.”
“The cost of the funds relates to the broader proposition, rather than being an unbundled charge for investment alone. Additionally, there will be distortion over shorter periods from the short time lag in pricing the funds.”
iShares Core MSCI Japan IMI UCITS ETF
Lastly we look at the $1bn iShares Core MSCI Japan IMI UCITS ETF.
iShares is the largest ETF provider in the world, with more than 700 products listed globally. It has scored very well in FE’s new ratings system, with the highest number of top-rated passive funds out of any firm, at 13.
However, one of its six lowest rated vehicles is the iShares Core MSCI Japan IMI UCITS ETF. Our data shows the ETF has had a tracking difference of 6.43 percentage points since its launch in September 2009 and a tracking error 4.62 per cent.
Performance of fund versus index since Sep 2009
Source: FE Analytics
A spokesperson from iShares says there are a number of reasons for those returns.
Firstly, the group changed the fund’s benchmark from the MSCI Japan to the MSCI Japan IMI in May last year and, secondly, iShares cut its total expense ratio in June 2014 from 0.48 per cent to 0.2 per cent.
Since these measures were introduced, iShares Core MSCI Japan IMI UCITS ETF has had a tracking difference of 0.2 percentage points and a tracking error of 1.8 per cent. This is only over a nine month period however, and the ETF will have to prove itself over a longer period before its rating is upgraded.