Passive investing is a good starting option for many first-time investors and can be the top choice among seasoned professionals as well, but picking the right tracker remains of utmost importance, according to the latest BMO Global Asset Management report.
Investors have increasingly turned to this area of the market. From 2006 to 2021, the amount put into tracker portfolios rose from £27.5bn to £297.9bn, to reach a total of 18.8% of the industry.
BMO’s PassiveWatch report looks at the returns of tracker funds, highlighting the disparity between some of the options in each market.
In the US, for example, the top passive fund returned 35% last year, while the worst performer made a loss of 6.3%. In the emerging markets this was even greater, with the top passive fund making 26.4% while the worst lost 23%.
Source: BMO PassiveWatch 2022
Adam Norris, investment analyst at BMO, said: “As usual, there is a vast range of performance between the best and worst passive funds due to the choice of index benchmark, charges, dividend policy, gearing, currency, tracking methodology and other features.”
The report found that these discrepancies are largely based on the country or style that the passive fund is tracking, suggesting that investors should still take an ‘active’ approach to picking these portfolios.
Extrapolating this over 10 years, however, passives tend to perform in a tighter performance band than their active peers. As the below chart shows, active funds in most regions have a broader range of outcomes than their passive peers.
Source: BMO PassiveWatch 2022
“The only sectors to buck the active trend were the US and global emerging markets – with the latter being won by the FirstTrust Chia India ETF, a passive fund providing sole exposure to Chinese and Indian technology stocks, yet again outperforming all active funds,” said Norris.
In the US, currency hedging played a part, while the dominance of the Nasdaq index were the main reasons for the divergence in performance.
However, over a 20-year investment period, the top active fund has beaten the top passive fund in every major market. In the UK, for example, the best active fund made almost five times more than the best passive alternative.
Investors looking to buy passive funds should monitor several things to make sure they are getting the best portfolio possible, the report said.
First is cost, which can eat into returns significantly. The range of passive charges can vary from as little as 0.05% to as much as 1.5% for some specialist trackers. Over a decade this equates to 0.5% and 16%, the report said.
Another is cash flow management – the amount of withdrawals and inflows that the fund deals with. Larger funds tend to be better at dealing with this as individual investor moves have less of an impact.
The third is track methodology, which include full replication (owning all companies in the index), sampling (taking a good percentage of the index), optimisation (similar to sampling but the stocks are picked based on their risk profile rather than being necessarily perfect matches), synthetic (using derivatives) and smart beta (style-based passives).
Norris said: “Selecting the appropriate index and analysing the costs of the product as a starting point is an obvious but important point to ensure the required market exposure is being taken.”
However, not all asset classes are ideal for passive investing, he noted, highlighting property as an example. It is possible to track real estate investment trusts (REITS) and property equities but buying bricks and mortar investments is not.
Credit market passives are another area where passive funds cannot compete with active managers, the report said, due the difference in how equity and fixed income indices are built.
“For instance, in a passive equity fund, when a stock price rises and the company is considered larger, all-else-equal, the larger proportion of the fund it comprises. Winners are therefore rewarded,” Norris said.
“However, in many credit passive funds the largest security tracked is often determined by the amount of debt outstanding. As a result, businesses with the most leverage outstanding are often those most highly tracked – not a characteristic that we necessarily want our portfolios to be exposed to.”
The BMO Multi-Manager Lifestyle portfolios has between 14–22% exposed to passive vehicles, with the remaining three quarters in active funds.
Source: BMO PassiveWatch 2022
Here the US and Japan equity markets are heavily represented by passives (a third of the total in these regions), while bonds and European stocks are lower at 20% of the total allocation.