Know what you’re getting into

This article is part of
Passive Investing - June 2014

When fund assessments, and with that fund manager assessments, are made in the active world, we often hear about the ‘whites of the eyes’ test – a theory that humanises what can be quite a numerical process and incorporates such characteristics as trustworthiness, confidence and chemistry.

But what about when there are no eyes whose whites you can test?

According to the IMA, £77bn was held in tracker funds in April 2014, comprising 9.8 per cent of UK retail assets, up from 9 per cent in April 2013. With the level of assets held in index-based strategies at its highest-ever level, momentum suggests that passive funds are here to stay. So how do you know which one to choose for your clients?

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“The first thing I’d look for is whether it was compliant,” says Peter Sleep, senior portfolio manager at Seven Investment Management.

“You need to look at its place of domicile, and where it holds it reporting status. Many passive funds are Dublin-domiciled, in which case any capital gains you make will be charged at your UK income tax rate, not your capital gains tax (CGT) rate.”

He stresses the importance of understanding whether you are in the fund’s income or accumulation units, but perhaps most important is understanding the actual index itself.

Gill Hutchison, head of investment research at City Financial, says advisers should beware making assumptions about the index their fund is tracking, saying Vanguard, for instance, on its US tracker products uses the broader S&P Total Market index, and in cases, a bespoke index of the highest yielding stocks, rather than the S&P 500 as might be assumed.

“This is not necessarily a bad thing, but it is likely to have more exposure to smaller companies,” she says.

“So particularly when you are working with models, as is increasingly the case, clients might wrongly think their allocation of 30 per cent to North America is matching the S&P 500.”

Mr Sleep explains that upon digging a little deeper than the fund factsheet, you might come across nuances at corporate level that make a significant difference. He claims that BlackRock, for instance, does not buy Indian and Russian shares in some cases, resorting to depository receipts or ADRs (in the US).

“So for emerging market equities, that is a fair chunk of the index that they are not touching,” Mr Sleep says.

But BlackRock countered that while it favoured replication, accounts were more difficult and costly to establish in certain markets.

Perhaps the safest option is not to treat passives any different than active funds, understand the known unknowns, and go in with your own eyes wide open.

Sam Shaw is a freelance journalist