Choosing the right passive investment is down to more than just looking for the cheapest product, according to Fidelity’s Sudi Gupta, who believes investors should be conducting thorough due diligence on index trackers. 
Passive funds have become increasingly popular with investors in recent years. The latest figures show 17.5 per cent of the Investment Association (IA) universe is now held in trackers (equating to total AUM of £251bn) while data from Calastone reveals that passives consistently attracted inflows in 2020 while investors were pulling money out of active funds.
Fidelity research analyst Gupta, who is responsible for heading up passive investments and indexed solutions research for the group’s multi-asset investment team, noted that passive funds made up 48 per cent of the global AUM in equity funds and 30 per cent for bond funds as of March 2020. This is up from less than 5 per cent in 1995.
However, he added: “The expansion of the passive universe and proliferation of available products makes the task of passive instrument selection increasingly difficult.
“While on the surface passive strategies may seem similar, we believe the universe of passive instruments is highly heterogenous. Investors are confronted with a large and continuously expanding choice of instruments tracking the same or similar indexes.”
As there is more than one way to take passive exposure, Gupta argued that finding the best strategy can allow investors to “eke out incrementally higher returns”. With this in mind he outlined the three considerations that Fidelity’s asset allocators look at when choosing a passive fund.
Passive fund provider
The first consideration is carrying out due diligence on the asset management house that is creating the index tracker or exchange-traded fund (ETF).
“We can use our relationships with passive fund houses to gain insight into their portfolio management and risk teams, systems used and the level of service they can provide us,” he explained.
Index
The next step is looking at the index being tracked by a passive solution, to ensure that the exposure it offers is in-line with the requirements of the end investor.
Gupta noted that some indices are overly concentrated in one sector, which means they might not be the most accurate way to express an investment view.
The liquidity profile of an index is considered, as this is reflected in the liquidity of the instrument tracking it. Highly liquid ETFs have tighter bid-ask spreads and this can reduce trading costs.
The research analyst added that developed market equity and government bond ETFs tend to be the most liquid, whereas emerging market, thematic and non-government bond ETFs may be less liquid.
“As an example, high yield bonds are an area where passive exposure is often inferior, as these ETFs tend to track a custom liquid version of a standard high yield benchmark and their bid-ask spreads can be wide as well as volatile due to the relative lack of liquidity,” Gupta explained.
“This can lead to a higher tracking error relative to the standard high yield benchmark exposure which you may be seeking.”
Instrument selection
The most important consideration is the actual passive instrument itself, according to Gupta. Several factors will be examined here.
One key element is tracking difference, which is the difference between the return of the fund and the index it tracks. A good product will minimise this difference, although factors such as currency used and the treatment of dividends can affect the performance of a tracker.
The replication methodology used by a tracker is also important. There are two main ways of tracking an index: physical replication, or actually holding the same securities as the index, or synthetic replication, which involves replicating its performance using derivatives and swap.
“Synthetic ETFs can offer advantages, especially for large or illiquid indices, where physical replication can be more difficult,” Gupta added.
“For example, most synthetic ETFs tracking the S&P 500 Index typically outperform physical ETFs, net of fees. One of the main driving factors of this is because they are subject to 0 per cent withholding tax, compared to 15 per cent for most physical ETFs.”
While some are wary of synthetic ETFs due to counterparty risk (or the risk that the swap provider could default on their obligations), the Fidelity analyst noted that this is also possible with physical ETFs that embark on security lending, or loaning out securities to other parties for the purpose of short selling. Both of this risks should be considered when looking at a tracker.
Costs are another area that the passive investor should pay attention to. “Analysts assess passive instruments on a total cost basis looking beyond the ongoing charge of a product, including factors such as bid/ ask spreads and other trading costs. Simply looking for the cheapest option does not deliver the best outcome,” Gupta said.
In addition, currency and tax considerations should not be overlooked. This might be considered whether to use a currency-hedged ETF or checking the tax implications that come with a fund being domiciled in a given country.
Gupta finished: “We believe there are several ways to use passive strategies most effectively in portfolios. Fidelity Solutions & Multi Asset is a large investor in passive instruments, often combining passive and active strategies in portfolios, or fully passive.
“When used as a complement to active strategies, we believe that passive strategies can also be particularly effective for capitalising on shorter-term tactical moves within markets because they provide direct and efficient exposure to diversified market betas (for example, an equity region which may offer tactical opportunities). On the other hand, we believe that less efficient, less liquid asset classes like high yield bonds are generally better accessed through active managers than passive strategies.
“We would encourage investors to review if they have invested in the most effective passive strategies and where it may be worthwhile looking for new options. While the headline cost may be an important factor, considering the total cost of ownership including trading costs, fund structure, replication methodology, liquidity and index composition are also highly relevant. The cheapest passive strategy does not always result in best net of fees returns.”