Selecting a passive fund might seem a less demanding job than picking an active alternative but advisers have been warned not to underestimate the amount of due diligence products such as ETFs deserve. Cost is far from the only factor to consider.
Here, three fund selectors discuss how they choose passive funds, whether to blend them and which type of investors they are best suited for.
What criteria do you use when selecting passives?
Capital Asset Management chief executive Alan Smith: We have an initial filter based primarily on costs. Any passive fund with an ongoing charge figure of over 50 basis points (and a number of funds remain above that level) is eliminated.
We then have a shortlist of funds and can drill down to the next level of due diligence. That considers tracking error, stock lending policy, where the fund is domiciled and reputation of the asset manager. We ask the asset manager to complete a detailed due diligence document at that stage.
Care is taken to ensure the right index is selected as there can be very significant differences, particularly in regions such as emerging markets.
Liontrust Asset Management head of multi-asset John Husselbee: Choosing a passive fund is labour intensive; the process carries many similarities to selecting an active manager. Our starting point is whether there is a passive offering available that is suitable to implement our strategy. The decision is simpler for the large liquid equity markets and less so for the fixed interest universe.
Then we look at how the index is replicated to start to assess the tracking error. Cost is of equal importance but here we are looking at overall costs rather than simply the annual management fees. Finally, there are the less obvious factors which can affect tracking error, such as stock lending or valuation point.
Square Mile investment research analyst Paul Angell: Our first criteria is to determine that an active manager is unlikely to be able to outperform an index over time, net of fees, within an asset class.
If we believe this to be the case, we will select a passive fund based on its cost, size, suitability of benchmark being tracked and performance track record.
We immediately screen out funds with an OCF over 30bps, as well as those with less than three years’ performance track record, those that track an obscure benchmark and those under £50m in size.
We then look at a fund’s tracking difference against its benchmark over time, blending its 12-month returns, over 30-day rolling periods, to smooth out the timing of pricing differences. We then select the fund that best matches its index.
As a final sanity check, we consider the extent to which the asset manager is committed to providing passive funds to the UK retail market.
How do you decide when to blend passives with active funds?
Husselbee: We establish whether there is a passive option available and suitable to implement our tactical asset allocation strategy, then we see whether we can identify active managers who can add value over the long term. We are happy to blend passive and active funds but unwilling to be compromised on price, focusing firmly on value for money.
Smith: We have not used active funds since 2009. After the financial crisis, we reviewed our approach and determined that actively managed funds fell as far and as fast as the market, and employing fund managers to protect the downside risk was a fruitless endeavour.
We cannot find evidence of anyone’s ability to identify in advance the very small number of managers who consistently generate alpha through skill, not luck. We do use smart beta funds, which have tilts to factors such as value stocks and small-cap, which are likely to generate greater than broad market returns without stockpicking or market timing.
Do you plan to increase your allocation to passive funds?
Husselbee: We are currently at a stage where we are happy with the balance between passive and active funds.
Angell: The sectors we have held passives in since the launch of our model portfolio in 2015 are US equity, alongside our preferred active managers, UK gilts and UK index-linked gilts.
While we are happy with our holdings across both passive and active funds, we may look to add more active management in the US equity space to protect against the narrowness of market leadership and increasingly high stock valuations.
Which investors are most suited to passive funds?
Husselbee: Not all asset classes have available and suitable passive offerings. For investors wanting outsized returns, active managers can offer this over the long-term, which may test the commitment of some investors.
Angell: With annual fees on passive funds as low as 0.06 per cent in the most liquid indices, the more cost-aware investors will naturally be attracted to passive funds.
More style agnostic investors looking for broad market exposure regardless of any value or growth biases are also more likely to select passive funds.
Finally, investors without the capability to do their own due diligence on active fund managers would also likely be better served by passive funds.