How passive funds really work

Passive investing is one of the simpler ways to invest in the stock market. Passive, or tracker, funds are convenient, low cost and simple to understand, generally investing in all the same stocks as an index – a basket of shares or bonds. They’ve been around for over 40 years and are becoming more popular with investors.

What isn’t always understood is what goes on behind the scenes. You might think it’s simply a computer, programmed to buy and sell exactly what stocks go in and out of an index. But that’s not the case. There’s often much more to tracker funds than first meets the eye.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. All investments and any income from them can fall as well as rise in value, so you could get back less than you invest.

The cost of tracking error

Alongside cost, one of the most important features of a tracker fund is ‘tracking error’ – how closely it matches the performance of the index. The lower the tracking error, the better job it does of mirroring index returns. Costs play a big part in this. Higher costs detract from performance, leading to greater tracking error – that can add up over time.

Tracking error is also affected by real-world implications that an index doesn’t take into account. After all, an index exists in theory, you can’t actually invest in it. Actual returns of tracker funds are held back by dealing costs, stamp duty, administration costs and taxes.

Then there’s dividends. An index typically takes them into account on the ex-dividend date (the date before which you have to own a stock to be entitled to the dividend). But a fund doesn’t actually receive them until a later date, creating a timing mismatch.

All these things added together can leave a tracker’s performance looking different to its index – not what it wants to happen. That’s where an active element, to an otherwise passive approach, steps in.

Adding Value?

Some tracker providers try to compensate for factors that hold back returns. There are lots of ways to do this, though there’s no guarantee they’ll always work. This can include:

• Partially replicating instead of buying and selling every stock in an index. This reduces transaction costs as providers decide which holdings should be bought and sold to represent an index’s performance. This often means the index’s smallest holdings aren’t traded.
• Using derivatives instead of physically buying all the shares in the index. Derivatives try to artificially recreate index performance through a financial contract. It can be a lower-cost method than physically replicating, but adds risk, because third parties are involved.
• Trading stocks before they’re added to or removed from an index. When a stock is promoted to an index, its share price sometimes rises or falls when it’s removed. A tracker’s team can try to profit by pre-empting these movements, although there’s no guarantee they’ll get it right.
• Lending stock, normally to short sellers – investors who borrow shares and benefit if the price goes down. In return, the fund receives a fee, which can help offset its costs. If used, it adds the risk that the borrower can’t afford to pay them back.

Let’s take a look at a fund from our Wealth Shortlist that uses some of these techniques.

The iShares Emerging Markets Equity Index fund run by BlackRock, tracks the FTSE Emerging Index. Emerging markets and smaller companies included in this fund are higher risk as they're at an earlier stage of development. The team use partial replication, holding around 1,650 stocks versus the benchmark’s 1,850. They exclude the smaller stocks which are difficult to trade, as the cost is much higher.

The team might also use derivatives to manage the fund. This involves using 'futures', which offer a quicker and cheaper way to invest in the broader index. They’re typically used when small cash flows come into the fund as these can be costly to trade.

BlackRock tracker funds typically use stock lending. Since BlackRock’s lending programme started in 1981, only three borrowers with active loans have defaulted. In each case, BlackRock was able to repurchase every share out on loan with collateral on hand and without clients losing anything. Although stock lending is not without risk.

These methods have helped keep the fund closer in line with the benchmark, over the long term.

Past performance isn’t a guide to future returns. Source: Lipper IM, to 30/04/21.

Help choosing a tracker – what to consider?

If you’re thinking about investing in tracker funds, you should make sure you know how they’re run. Information on replication, stock lending and derivatives can all be found in a fund’s factsheet and Key Investor Information Document (KIID) – you can find them on the HL website.

Using different techniques to compensate for tracking error isn’t necessarily a bad thing. They can be used effectively, but you should make sure you’re comfortable with the potential risks involved before investing.

The last point to think about is checking how closely a fund has actually tracked its index. Most funds show this visually in a graph on their factsheet. The closer a tracker fund’s performance line is to the index’s, the better. Remember though, past performance isn’t a guide to the future.

Researching funds can be a time-consuming process. To make things easier, we have our Wealth Shortlist of funds. These funds have been chosen by our analysts for their long-term performance potential. Within the Wealth Shortlist you’ll find a range of funds, including tracker funds.

The Wealth Shortlist is designed for investors comfortable in picking their own investments. Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

This article originally appeared on Hargreaves Lansdown.