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FE Passive Fund Rating methodology


FE has designed a way of rating both passive funds and ETFs, based on their ability to track and match their chosen benchmarks.


FE has long rated managers’ ability to outperform, but the original FE Crown Fund Rating does not do justice to the growing passive fund market, which currently accounts for over $100bn in the UK alone.

Unlike an active fund which attempts to beat its designated benchmark, passive funds and ETFs attempt to track their index, with the aim of delivering a return as closely in line with it as possible. Comparing active and passive funds using the same rating methodology is therefore flawed.

As a result, FE has introduced the FE Passive Fund Rating. Passive funds will be awarded between one and five Passive Crowns, based on their ability to track their index over a three year period. We have 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. 

It should be noted that passive funds generally have a much more focused objective than active funds, with the result that the range of outcomes is narrower for passives than for actives. Consequently the performance differences between top- and bottom-rated funds are narrower for passives.

Which funds and ETFs qualify?

FE rates around 250 passive funds available for sale in the UK across the IA UT/OEIC, Offshore and ETF universes, which between them track around 60 indices. Only funds with a three year track record qualify for a rating, and only those available for sale in the UK are included.

The funds included can be split into nine broad asset classes:

- UK Equities
- US Equities
- European Equities
- Japanese Equities
- Emerging Markets Equities
- UK Gilts
- UK Index Linked Gilts
- Sterling Corporate Bonds
- Property

There are of course many more than 250 passive funds and ETFs available for sale in the UK, but FE will only rate funds whose benchmarks reflect the main types of investment that a UK investor would be interested in. So, a number of passive funds that track commodities indices, leveraged and reverse trackers, as well as “smart beta” products, are excluded.

FE Trustnet readers will still have access to these in the ETF section.

 
Rating Method

  1. Rating Components

FE uses three components when calculating the FE Passive Fund Rating. Tracking difference is the most influential component, followed by tracking error and fund size.

- Tracking difference
, which calculates the annualised relative performance of a fund compared to the underlying index over a three year period. For example, if a fund returns 10 per cent over 12 months and an index returns 12 per cent, the tracking difference is 2 per cent.

- Tracking error, which calculates the volatility of the difference of the returns between a fund and its benchmark. For example, a fund that perfectly replicates the performance of its underlying index every day over a 12 month period, its tracking error will be 0. However, if a fund deviates from its index on a regular basis it will have a higher tracking error, even if the tracking difference after 12 months is 0.

- Fund size. While this is not typically discussed when comparing tracker funds, FE sees it as important.  

- Bearing in mind the type of underlying indices we are considering, it is generally desirable for the fund to have a certain level of scale in order to make the hard work involved in physical replication an economic proposition. Funds are therefore rewarded for being larger.

- ETFs are listed vehicles. Better liquidity should result in lower buy/sell differentials. In the absence of being able to track buy/sell differentials directly, FE views size as a reasonable proxy for liquidity.


   
  2. Scoring system

The number of Passive Crowns is determined by an absolute score based on these three components. Unlike the FE Crown Fund Rating, we will not be distributing funds across the ranks according to quartile positioning. For this reason, it could be that there are no five Passive Crown rated funds, though this is of course highly unlikely.

Scoring is as follows:

Tracking difference

- If a fund has a tracking difference less than or equal to 0.4% of its benchmark on an annualised basis, it scores 10 points.
- If a fund is within 0.4% - 1% of its benchmark on an annualised basis, it scores 5 points.
- If there is more than a 1 per cent difference between a fund and its benchmark on an annualised basis, it scores 0 points. 

Because of the difficulty and expense of tracking Emerging Markets indices, the limit for getting the maximum 10 points is raised from 0.5% to 0.75%. For a fund to get 5 points, it must be within 0.75%-1% of its benchmark, and anything over 1% will result in 0 points.

 
Tracking error

- If a fund has a tracking error less than or equal to 0.5% on an annualised basis, it scores 5 points.
- If a fund has a tracking error of between 0.5% and 1 per cent on an annualised basis, it scores 2 points.
- If a fund has a tracking error of more than 1% it scores 0 points. 


Fund size

- If a fund is more than £100m in size, it scores 2 points.
- If a fund is between £30m and £100m, it scores 1 point.
- If a fund is less than £30m in size, it scores no points.


Passive Crowns  

- To get the maximum 5 Passive Crown rating, a fund needs to score the full 17 points
- To get 4 Passive Crowns, a fund needs to score between 15 and 16  
- To get 3 Passive Crowns, a fund needs to score between 12 and 14
- To get 2 Passive Crowns, a fund needs to score between 8 and 11
- Funds with less than 7 points get 1 Passive Crown.



General considerations

Price type
: FE uses net total return for both funds and indices when calculating the rating. Total return for funds is net of management fees.

Pricing frequency: FE uses daily values when calculating the Passive rating. In the case of ETFs, we have used when possible NAV (net asset value) prices directly supplied by the manager, rather than exchange-sourced end of day prices.

Valuation points: ETFs and indices are generally measured as at the market close of the relevant market. UK funds often value at 12 noon. This can give rise to disparities in tracking error. Where possible for these funds, FE has used index values as at 12 noon.

Performance and charges:

- Performance data is inclusive of management costs, but total declared charges are not always wholly transparent, particularly for synthetic trackers. Very often the real cost of the swap fee with the swap counterparty is not fully revealed.

- Performance and charges can also be distorted by differential tax treatment. Depending on the domicile of the fund, and the location of the components of the underlying index, withholding taxes can cause different outcomes.

- Performance and charges can be further affected by returns obtained from stock lending, which is a practice particularly used by physical trackers. Generally the less developed and less liquid markets offer the best stock lending returns.

- These factors are what have led FE to rely mainly on tracking difference for its rating, since this is what shows the overall net effect of these factors.

Data provided by FE. Care has been taken to ensure that the information is correct, but FE neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.

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