What are the key considerations?
Caroline MillsAnalyst, Manager Research
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When creating a robust multi-manager solution, much effort is usually undertaken to establish preferred active managers, while passive funds have historically received less attention from a manager selection perspective.
Despite this, the passive equities asset class has been growing rapidly. Over the last 10 years, according to eVestment, passive equity AUM has grown by 3.75x in comparison to 1.9x for active equity management.
THE NUANCES OF PASSIVE EQUITY FUND SELECTIONWhat are the key considerations?
So, with this in mind, let’s consider the key nuances within passive management that can make a notable difference in performance over the long term – and key considerations for passive fund selectors.
Most investors focus on the headline charges when selecting a passive manager. However, whilst fees are very important, subpar passive management can lead to higher transaction costs and/or unexpected performance deviations from the chosen index. This means that the cost of poor passive manager performance can outweigh the fees saved.
Having a large pool of assets makes it more cost-effective to hold a greater proportion of the index constituents. In this instance, a manager may be able to offer full replication, where every security in the index is held. An asset pool that is smaller or is tracking an index of securities that are more expensive or illiquid to trade, may be run on an ‘optimised’ basis. This is where a manager may select a representative sample of securities from the index, seeking to reflect the index in terms of key risk factors and other characteristics.
Business and Resourcing We find that best-in-class asset managers have the majority of their overall AUM in indexation strategies. This simply means that this area receives sufficient analytical and operational resourcing given the importance of this area to the business.
Index analysis The most efficiently resourced passive businesses have a centralised research team that is dedicated to analysing the evolution and trends of index changes as well as the management of corporate actions. This allows there to be uniformity in decisions across the firm as the portfolio managers are leveraging off a centralised research platform.
Value enhancing techniques Managers need to conduct a series of value-enhancing techniques in order to overcome the costs of replicating an index. A good passive manager will be able to provide at least the benchmark return plus a marginal amount of excess return.
These techniques include, but are not limited to:
Internal cross-trading: We find one of the largest sources of value enhancement to be from trading through internal sources of liquidity. When a trade is able to be crossed in-house, the client benefits from far lower costs and minimal market impact.
Derivatives: These are typically used for cash management purposes in order to manage client redemptions. Using futures within the fund management process can help minimise the cash drag within the portfolio and improve tracking of the portfolio. This is because futures can provide a low-cost method of gaining exposure to the underlying index without losing liquidity.
Index changes: Managers are able to reduce costs through effective management surrounding index rebalancing. This often involves identifying high-conviction prediction trades prior to the announcement of an index rebalance in order to come up with the most suitable trading strategy. Following the announcement, managers can minimise trading costs by trading around the effective date.
Sophisticated passive managers use portfolio management and optimisation tools. These systems help portfolio managers with cash management and managing stock deviations from the benchmark whilst minimising trading costs. In addition, the risk management capabilities embedded in these tools allow for more robust protection relative to the likes of an Excel model.
Lastly, we find that passive managers who have a global trading presence benefit from local traders' knowledge and the lower trading costs in local markets. In addition, sophisticated trading software explores internal liquidity options before sending the trades to the open market. This enables the end client to benefit from lower fees.
Although a less sophisticated manager may be able to track an index, we find that the value-enhancing techniques applied can make a big difference in performance over the long term. To illustrate this, we have plotted the cumulative monthly returns of two passive funds along with their relevant underlying index, MSCI World, over a 10-year horizon.
As you can see, Manager A has significantly outperformed Manager B, whilst both managers are tracking the same index.
In a nutshell, this illustrates the importance of looking ‘under the hood’ when selecting a passive manager – and the value in considering the above nuances when identifying those that can successfully track an index, at low costs, whilst providing marginal excess returns.
Are you looking to judge the pros and cons of a passive investment strategy? Our team can help you clarify the nuances in approaches to passive fund strategies and work with you to deliver the best outcomes for your mandate. Don't hesitate to reach out.