What to consider when buying a passive fund

With passive investing continuing to increase in popularity throughout 2020, investors must remember selecting a passive fund is not a straightforward task, according to Nick Wood, fund expert at Quilter.

The first half of this year saw continued outflows from active funds as the Covid-19 crisis took hold, however according to data from Refinitiv Lipper, passives have been roughly flat in the US and witnessed strong inflows in the UK.

However, with passive funds benefitting from a strong tailwind and often beating their active rivals on both price and performance, Wood believes investors still need to do their homework and not be under the impression that every index is the same.
“Whilst passive investment would seem to take away the difficult decisions around selecting an outperforming manager, there are a still a number of factors investors need to consider to get the best outcome,” Wood says.
“Even in this area, there continue to be enhancements to how they are managed and created by fund groups. For example, we have seen BlackRock branch out into the synthetic ETF space, so it will be interesting to see how things develops over time in that area of the market, both in terms of popularity and broadening out to other products.
“That said, as passives become increasingly part of the investing landscape, there is a growing list of considerations that need to be taken into account, and as such research is becoming vitally important.”
Below, Wood provides four things to look for when selecting a passive fund.
Choosing the right index
“There are many very similar indices within individual markets. A good example comes from the US, where the S&P500 and MSCI USA have diverged this year by around 2%, having largely tracked each other over time prior to that.
“Normally minor index constituent differences aren’t enough to make a big difference, but when that difference is Tesla, part of the MSCI index but excluded from S&P methodology, that has resulted in a meaningful gap this year.
“Equally, small differences in indices such as a slightly broader set of constituents including smaller companies or use of alternative index providers can have a meaningful impact in the world of passives.”
“A lot of investors place a lot of focus on cost now, and although passive fees have fallen steadily there can be meaningful disparity between products. By simply tweaking your index requirement, you may find a much cheaper product.
“There are examples of very similar products at the same provider priced quite differently depending on the index chosen. It’s also noticeable that as active fees decline, in some areas where passives are a little more expensive, the active alternatives can sometimes get a lot closer to passive fees than they used to.”
Physical vs synthetic
“Synthetic ETFs are where the manager uses instruments such as derivatives and swaps to get exposure to a market return rather than through simply buying the underlying index constituents. This is a good example of where investors might want to take a view either way.
“Synthetic products can potentially be riskier, especially in more illiquid markets. Equally, in the case of the S&P500 ETF, perhaps risks are a little lower in such a large and liquid market.
“Finally, synthetic ETFs have certain tax advantages over their physical counterparts, but one might argue that for a few basis points, the potential risks and complexity of a such a product just isn’t worth the switch.”
“You might choose a passive vehicle that formally excludes parts of the universe, such as so-called sin stocks, but in some ways that’s really the same as choosing your index, in this case one excluding certain area for example.
“The other area you might want to consider if you want a more ESG focused manager is how much they engage with their underlying company holdings on your behalf. Clearly a small number of passive groups manage a huge amount of global capital and have significant influence and choose to use this to a greater or lesser degree.
“Like active managers, some passive providers continue to up their game in this regard, not least due to external pressure from investors. We have been fairly impressed with L&G and how they engage with companies for example.”