Although the popularity of passive strategies in recent years has been fuelled by their relatively low costs, asset manager Vanguard believes investors should take other features into consideration when buying an index tracker.
Retail sales of tracker funds have continued to grow in recent years and 2019 looks to be a bumper year with 11 months of data for the Investment Association showing net retail sales of £16.2bn.
As inflows continue to find their way into the strategies, funds under management have reached 17.6 per cent of the UK retail industry total (as of November 2019).
Source: Investment Association
However, with greater passive flows there has come greater competition on costs between product providers.
This has driven down costs to a point where there are just a few basis points between providers.
“Expense ratio differences that have a material impact on a fund’s relative performance at 50, 20 or even 10 basis points verge on irrelevance at one-to-two basis points,” Vanguard said.
“At these levels, performance – and due diligence – depends on less visible and more complex elements of fund management.”
As such, the real savings achieved by switching to lowest cost product have been minimised or eliminated.
Instead, investors should take into account expenses and organisational incentives, portfolio management capabilities, securities lending, pricing strategies and scale “in more equal weights than in the past”.
Below, Vanguard highlights what – other than costs – investors should consider when choosing a passive strategy.
Aligned incentives
One of the things that investors should consider when choosing a passive provider is aligned incentives and how that might affect an investor’s returns.
As the costs of a fund are deducted from its net asset value and detract from performance, investors should seek out asset managers with disciplined expense management.
“Understanding a manager’s track record aids investors in determining how that manager will treat clients over time, such as the likelihood that costs will remain flat or decrease rather than potentially fluctuate over time when selective price competition is a business strategy rather than a core philosophy,” the asset manager said.
Secondly, the ownership structure of an asset manager can also help avoid conflicts of interests, Vanguard noted.
“The owners of publicly-traded or privately-owned firms may have competing interests with those of their fund investors,” the firm said.
“Mutually-owned, or similarly structured, asset managers, on the other hand, can offer better alignment with investors' objectives.”
Portfolio management capabilities
While some might consider index-tracking to be relatively straightforward, the passive giant argued that it is in fact more complex than many appreciate.
In judging a passive asset manager’s capabilities, investors should look at excess return and tracking error as measures worth considering.
Excess return – which measures the extent to which an index fund has out-or underperformed its benchmark – should usually be negative for tracker strategies.
However, some managers can seek positive numbers that offset costs by taking advantage of corporate actions such as mergers & acquisitions that change the composition of a benchmark.
Tracking error – which measures the consistency of a tracker fund’s return relative to its benchmark – can serve as an indication of the risk present in a manager’s process.
Both should be viewed together to determine how skilfully a fund is being managed.
Source: Vanguard
As the above chart shows, while Fund A shows a higher average excess return than Fund B, its tracking error is significantly higher. This could result in different outcomes for different investors.
Securities lending
The loaning of portfolio securities to other financial institutions – such as hedge funds – can result in additional revenues for passive managers.
However, investors need to consider whether they are being adequately compensated for the risk being taken.
“Asset managers can differ significantly in terms of how much their securities lending revenues they return to investors and how much they retain as profit,” the firm noted.
“The percentage of gross revenue returned back to the shareholders from a securities lending programme may range anywhere from over 95 per cent to as little as 35 per cent, and thus it is important to understand what, if any, portion of revenue is retained by the asset manager when considering the quality of, and incentives behind, a securities lending programme.”
In addition, investors need to understand an asset manager’s lending philosophy.
A value lender will lend small amounts of hard-to-borrow securities where demand is high, as are fees. A volume lender will attempt to maximise a larger part of their portfolio, thereby increasing risks of a borrower default or collateral reinvestment.
Scale
Finally, while economies of scale can be achieved in passive asset management, it is becoming increasingly difficult to achieve.
As such, the size of an asset manager can determine a range of other issues, according to Vanguard.
Scale can determine how high or low trading costs will be, offering the opportunity for cross-trading within a range eliminating brokerage commissions or by aggregating large orders at lower commission.
The size of a passive asset manager can also open up greater opportunities in securities lending with a broader range to lend and ability to fill large orders.