Passive funds’ growing popularity should be celebrated, since they allow investors to build efficient and low-cost diversified investment portfolios. But it could also be argued that the rise of passives has made investing more difficult for many investors and their advisers.
It may sound counter-intuitive – after all, passive funds simply track indices that are designed to represent a particular asset class or market – but the proliferation of passive offerings, especially exchange-traded funds (ETFs), is making selecting the right product ever more challenging. There is nothing passive about choosing a passive fund. Indeed, investors must be aware that through the selection of the underlying index, they are effectively making an active asset-allocation decision. And this is crucial, as no two indices are the same.
Take the example of the UK equity market. There is a difference between buying a FTSE 100 tracker and a FTSE All-Share tracker. The FTSE 100 index represents about 85 per cent of the UK equity market’s capitalisation, but solely focuses on large caps. By contrast, the FTSE All-Share index, which captures 98 per cent of the UK stockmarket, allocates about 80 per cent of its value to large caps and 20 per cent to mid and small caps. This difference in breadth between the two indices has led to different returns over the past decade.
Similarly, a fund tracking the MSCI World index will yield different results from one tracking the FTSE All-World, as the former provides virtually zero exposure to emerging markets, while the latter allocates about 8 per cent to the asset class. Put another way, benchmarks – and funds tracking them – sharing the same marketing name, World in this case, can be very distinct investment propositions.
The rise of smart beta has arguably made fund selection even trickier. The emergence of novel and increasingly complex indices places a significant education burden on investors who now need to educate themselves about factors, such as value, momentum and low volatility that promise higher returns and/or lower risks. That’s just the first step. Once you grasp the meaning of factors, you need to closely inspect the various strategies on offer, as similar products can result in considerably different risk-return profiles due to their different construction rules.
If all this wasn’t difficult enough, the situation is being made ever more complicated as new smart beta indices often rely on newly defined factors. Fund sponsors and index providers tweak the factors originally defined by academia to make them ‘better’, and demonstrate –through the use of back tests – that their approach leads to improved results.
The problem is that back tests can be the product of data mining, or testing many things to obtain a desired result. Studies show that many new smart beta strategies, once live don’t perform as well as they did in the back tests. This poses a reputational risk to the passive fund industry. More importantly, it serves to underscore that investors should always take back tests with a huge pinch of salt.
