How to advise on index tracking funds


    • Ongoing charges.

    • Number of distribution partners (Oeics and unit trusts only) – a key plus for any fund is being available through many platforms.

    • Fund size – it is generally accepted that most funds are not particularly profitable or comfortably sustainable until they reach a certain size.

    • Group AUM – gives an indication of scale and resources.

    • Return on any stock lending for funds that hold physical securities.

    • Counterparty risk for funds that engage in synthetic replication.

    • Undertakings for collective investments in transferable securities (Ucits) compliance and domicile – a key plus for any fund today is having Ucits status, because it gives investors some assurance that certain regulatory and investor protection requirements have been met.

    These are added up to give an overall Diamond Rating, with 5 indicating the best quintile in that market and 1 the worst. When totalling the individual scores, the above factors are weighted such that ability to track accounts for half of the Diamond Rating.

    We always keep an eye on market developments and regulatory influences and may sometimes update our rating criteria in order to remain up-to-date.

    Combining active and passive

    There can of course be both active and passive investments in an investor’s portfolio. Many people believe some markets, such as US equities, are very efficient and already highly researched by fund managers and analysts.

    Therefore, index trackers might be best for that part of a portfolio, as it is harder for a manager to add any further value. Emerging Markets, however, are less efficient and researched, offering more scope for active management in that area.

    Other studies, though, have shown high proportions of active managers of less ‘efficient’ asset classes have underperformed their benchmark, with there being a greater percentage of underperforming managers than for the more efficient classes.

    The less efficient classes will generally have higher fees than the more efficient ones. For example, Emerging Market equity funds will often be more expensive than US or UK equity funds on average, while high yield bond funds normally cost more than investment-grade bond funds.

    Therefore, on a gross basis, the manager of the less efficient and more expensive asset class starts ‘further behind’ the index, which means they will have to beat the index by a greater amount just to break even.

    Whichever one of the above competing thoughts investors believe in, there may be occasions when it makes sense for them to hold both active and index funds within the same asset class. When using active managers, investors face a relatively wide distribution of returns.

    When combining an active fund with an index fund for that asset class; however, the distribution of potential returns will be dampened – there will be fewer very low return outcomes, but also fewer outcomes of very high returns. For the adviser, this reduction in the distribution of returns should reduce ‘client risk’ – the chance of clients leaving if their returns fall below a certain level.


    Questions appear on the last page of this article.