What to consider when selecting passive products

In today’s low-growth, low-interest rate environment, passives promise an attractive mix of low costs and simplicity for investors. Yet it is essential that investors have a fundamental understanding of why the strategy works, and to be aware of the pitfalls.

In theory, selecting passive funds should be quite straightforward. This is certainly true when compared with the work required to identify suitable active funds, but challenges still remain. The range of options for passive investment has expanded significantly in recent years as the ETF industry has developed, and if systematic smart beta options are included, the choice becomes overwhelming.

Passive products have featured on Square Mile’s Academy of Funds recommended product list since August 2015, and it now includes 61 trackers. 

The research has been narrowed to mainstream open-ended vehicles. There are well over 1,000 listed ETFs available to investors, with many following a smart beta approach. However, the question that still dominates is whether smart beta approaches should be considered passive or active management. Value indices, for example, can be defined by stock metrics such as price-to-book, price-to-earnings, price-to-cashflow, or through a combination of these factors. 

Given that identifying the most appropriate ratio requires a subjective judgement, it is reasonable to believe that smart beta strategies entail a due diligence approach more in keeping with active funds. Hence they were excluded from Square Mile’s passive fund review.

As it happens, the traditional core market cap-weighted-based index funds attract most inflows.

But there are dangers lurking inside traditional market-weighted indices that may catch the unwary. For bond investors, price appreciation and longer maturity issues mean that, to obtain a similar level of interest rate risk in portfolios, buyers of the conventional gilt index need to take only two thirds of the allocation they did 10 years ago. I suspect that few advisers are aware of this.

Non-traditional areas are targeted by more aggressive passive investors, which may involve taking exposure to less liquid parts of the equity or fixed income market. Flows into small-cap index funds have been relatively low, but global high-yield bond indices have attracted a considerable following over the years. 

Were credit markets to seize up again as they did in 2008, passive funds could suffer a severe liquidity squeeze if hit by heavy redemptions, and this could intensify pressure on prices.

Last but not least, selection impediments can be caused by the mismatch of the fund pricing time (often midday) and the index pricing time at the close of business. This is an issue that affects many active funds as well: for example, the IA North American sector tends to outperform during months when the S&P 500 slumps on the final trading day of the period. 

Of course, what is gained in one month is recouped in the following month, but the distortion can catch out the unwary.

Jason Broomer is head of investments at Square Mile Investment Consulting & Research

KEY FIGURES

€615bn

Assets under management in European ETFs at the end of August

9.5%

Strategic (smart) beta ETFs’ share of net sales in the second quarter of 2017

13.7%

Tracker funds’ (ex ETFs) UK market share in terms of assets under management, up 1 percentage point in 12 months