Want Transparency When Investing? Opt for Passive Funds

By virtue of simply tracking an index, passive fund managers are not under pressure to keep information on fund holdings away from public eyes. There is nothing to hide

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Investing is all about taking risks on the expectation of a return. By nature it is an activity fraught with uncertainty and investors have little option but to accept the unpredictability of returns. We are constantly reminded that past performance is not a guide for the future, however investors can take steps to minimise the ignorance of the risks assumed.

The growing popularity of passive investing over the last decade has been partly predicated on the high level of transparency associated with the management of passive funds compared to the active side of the industry.

Passive funds, particularly so exchange traded funds (ETFs), have been the subject of close scrutiny by regulatory bodies, international research bodies and media commentators. The passive industry’s response to this scrutiny has been one of maximising transparency in all aspects relating to the management of the funds, including comprehensive, regularly updated and, more important, easily accessible information of fund components.

It goes without saying that by virtue of simply tracking an index, passive fund managers are not under pressure to keep information on fund holdings away from public eyes. There is nothing to hide. The benefit for investors is one of having full information to help them make an investment decision.

The same cannot commonly be said for active managers, who routinely justify non-disclosure on the basis of protecting their investment ideas from competitors. While accepting the validity of this argument, the reality for investors in actively-managed funds is that in many instances they are left in the dark as to what fund managers do with their money. Ultimately, this may make them unable to properly assess whether the fees payed out are justified.

Finding out that an active fund manager lost you money because of an ill-fated bet on Greece only when you get your annual statement is not particularly helpful. However, the need for increased transparency is not only justified for the eventuality of extreme market events. 

While ETFs have become a vital part of the investor toolkit, but many misconceptions about the products remain.

Myth 1 ETFs Always Deliver Average Performance

One of the most pervasive myths surrounding passive investing is also one of the most inexplicable given that it doesn’t stand up to even the most basic scrutiny. In this case, we don’t even need to get bogged down in the theoretical merits of active versus passive investing, a brief look at the numbers will suffice.

If we take as an example the popular iShares Core S&P 500 ETF, which tracks the S&P 500 index for an annual fee of just 0.07%. This fund has landed in the top decile when ranked against its US large-cap peers on a risk-adjusted basis over 3 and 5 year periods, this stellar performance can be extended out to ten years if we look at older funds which track the same index. It is clear this performance is anything but average.

Of course, there are markets in which active managers have enjoyed greater success, but when considering any investment, it pays to disregard received wisdom and allow the numbers to speak for themselves.

Myth 2 All ETFs are Trackers

Although the vast majority of ETFs track an index, there are a small but growing number of active ETFs which do not. When we talk about ETFs we are talking about a flexible investment vehicle that allows funds to be priced and traded throughout the day like a stock. This can be contrasted with the traditional priced-once-a-day mutual fund structure, which many see as archaic.

The transparency and rules-based predictability offered by index-tracking strategies makes them a perfect fit for the ETF structure. However, as the industry continues to grow, we shouldn’t be surprised if we see more and more active managers entering the market by repackaging their active strategies in an ETF wrapper.

3 Questions worth asking your passive fund to selecting the right product:

Question 1: What Index Does it Track?

Don't assume that passive funds in the same category track the same index. For example, many funds track the S&P 500, but some providers also offer ETFs that tracks the 750 largest U.S. stocks, giving it a slightly larger exposure to mid-cap stocks, even though it and the S&P 500 funds all land in the large-blend category.

Likewise, many funds track MSCI indexes, but Vanguard's foreign-equity funds track FTSE indexes. One key difference: FTSE counts South Korea as a developed market while MSCI counts it as an emerging market.

How you can tell: Read the passive fund's prospectus closely to find out what index it tracks, or read the Fund Analyst Report. It's also a good idea to look at the fund's portfolio, under the Portfolio tab, to check out allocation, sector, and regional weightings.

Question 2: How Well Does the Fund Do its Job?

Of course, a passive fund's job is relatively straightforward: track an index as closely as possible. Yet, some do this better than others. So-called "tracking error" refers to gaps in the performance of a passive fund relative to its benchmark. Because passive funds cost money to run, some tracking error naturally results from subtracting these expenses from the fund's performance. Yet, some funds find ways to limit this error. 

Another way passive funds can limit tracking error is by limiting their use of sampling, a method used by some passive funds to approximate the performance of hard-to-buy securities – such as the stocks of very small companies – rather than owning each of those securities individually. These ETFs are called “synthetically backed”.

How you can tell: Check the fund's performance relative to the benchmark, and relative to its competitors that track the same index. If your fund's performance tends to vary more widely than its competitors', this means that tracking error is a problem, even though the fund could end up performing better than the competition and even the index because of it.

Question 3: What Role Does the Fund Play in Your Portfolio?

As with active funds, a passive fund should fill a specific need in your portfolio. The good news here is that, unlike with active funds, performance should be rather predictable; you can expect close to the index's return no matter what happens.

However, just because you own a passive fund doesn't necessarily mean you are well diversified. If your portfolio consists of only equity passive funds, you may be neglecting bonds which could provide diversification and stability of returns.

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Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure

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