Doing Proper Due Diligence On Passive Funds

All too often it seems that investors focus on one or two factors when assessing passive fund managers, at the exclusion of the bigger picture. Perhaps the two most common factors would be fees and tracking error.  But the assessment of passive fund managers is not as simple as what investors initially assume. A more comprehensive set of factors should be taken into account.

Don’t Base Your Decision On Fees And Tracking Error Alone

Whilst fees are an important factor to take into account, the lowest fee manager may not deliver what the investor needs, which is a product that will effectively track the index. A similar argument can be made for tracking error, as statistics can give a highly misleading picture if the manager happens to price their product at a different time of the day to the benchmark.

As with active funds, a research process for passives should incorporate both quantitative and qualitative elements. Quantitative analysis is used to assess the past performance of the manager as well as their tracking error. Qualitative analysis is used to form a view of the manager’s capabilities to execute their passive strategy effectively on a forward-looking basis, through assessment of their business, team and investment process.

Passive Manager Assessment Criteria At RSMR

Within the business criteria, stability and alignment with client interests are important. We particularly like businesses that are focused solely on managing passive funds, rather than spreading their activities across a number of different areas. Scale and sizeable assets under management are also critical within passive fund houses, as bigger size brings lower fixed costs and more opportunities to internally cross trades, thereby avoiding external trading costs.

Look At The Whole Team

The “team” category is concerned with its size, focus and turnover. We prefer teams that are solely dedicated to passive management and are based at one location to make internal communication more efficient. The qualifications and experience of team members should also be taken into account along with levels of staff turnover. High staff turnover levels can indicate underlying problems in the business.

Process Matters

Managers can differ in the degree to which they track the index, ranging from fully replicated to more optimised approaches. Full replication minimises tracking error but can increase costs; whilst optimisation can be cost effective, it also involves higher risk. We look for managers who find the appropriate balance between the two extremes. This can differ based on the market they are trying to replicate.

We also analyse the techniques that managers use to add value, such as stock lending, as well as their use of trade crossing opportunities and enhanced trading techniques around index changes and corporate actions.

Product Comes Last, But Not Least

The final category that we analyse is the product itself. At this stage, the past performance of the products should be analysed along with the tracking error relative to the benchmark. We also look at the provider fees in the form of both annual management charges and ongoing charge figures. The ideal combination is a manager who tracks their index with as little performance drag as possible, has a low tracking error and charges a low fee.

Importance Of Fund Ratings

We recently carried out a review of the passive sector, looking at the open-ended fund products of the big six providers within the UK, who represent the main bulk of the market. These six managers were sent a detailed questionnaire for both their equity and fixed income products. The responses were then collected from the managers and were analysed for issues and weaknesses that could be addressed in meetings with the manager.

An in-depth meeting was carried out with each manager, which typically lasted around three hours. These meetings were an opportunity to meet professionals from the equity, fixed income and risk teams in order to assess their capabilities in more detail and address any issues that had arisen from the review of the questionnaires. After completion of the meeting, the strengths and weaknesses of each manager were assessed based on set criteria. Consistency in criteria was essential so that each manager was compared and contrasted on a like-for-like basis.

All of the above stages in our research highlight the need for stringent and detailed due diligence in the passive fund world – our decision when rating a tracker fund does not just come down to tracking error and annual costs alone. Advisers will realise that manager scrutiny and rigorous analysis – not reserved to the realm of active funds – can be applied more broadly within the investment universe.

Chris Riley, CFA, is investment research manager at Rayner Spencer Mills Research.

RSMR’s ratings are available on its website and can be used to populate client portfolios with passive funds. More information and RSMR’s passive investing guide is free to download on its web portal.