In this article, we answer this one simple question, while dispelling six myths around passive investing.

Myth 1: Passive funds are run by computers and algorithms

If only it was so easy. While computing power can provide a degree of automation, the complexity of passive management requires human knowledge and expertise to ensure close benchmark tracking.

Passive fund managers can design algorithms to improve the efficiency of their process, mitigate tracking error or remove some of the manual work involved in running their funds. However, the level of sophistication of such algorithms is limited. Experience and knowledge cannot be underestimated when it comes to interpreting corporate events, efficiently managing cash flows, and calculating trade cost analysis. Not to mention dealing with challenges such as market holidays, trade volumes and nuances with trading certain assets across global markets.

Myth 2: Passive fund managers simply buy all the constituents of the benchmark

Passive funds seek to replicate the risk and return profile of an underlying benchmark. The simplest way to do this is to buy all the underlying benchmark constituents in line with their index weights.

This may be straightforward for a fund tracking the FTSE 100 for example, where all the constituents can be purchased at benchmark weights with no real constraints on size, liquidity, minimum trading lot sizes and no complications with multiple currencies. However, if a benchmark is a global emerging market index, there could be almost 1,500 lines of securities in over 25 countries and as many different currencies. Some stocks may be illiquid while others may not be available to buy due to foreign shareholder restrictions or limitations with third party providers.

When it comes to bond indices, they have tens of thousands of constituents and it may be simply impossible to buy all of them. Some bonds are also hard to source and may not trade from one month to the next. Pricing may be opaque and data limited.

This is where the skill of a fund manager, to construct sampled or optimised low tracking error portfolios, adds value.

Myth 3: Equity and bond indices are static

On any given day, our universe of thousands of securities will see a lot of changes. There may be dividends and coupons going ex or being paid, mergers and acquisitions, companies coming in and out of indices, stock splits or rights issues. That is in addition to the periodical index rebalances where constituents may become eligible/ineligible to be part of an index, and therefore of a fund.

Passive fund managers have to navigate all these issues to ensure the performance of their funds closely matches the underlying benchmark returns while minimising transaction costs and spreads.

Myth 4: Cash flows are simply invested in the benchmark constituents

Indices have no cash flows – but passive funds do. Management of cash flows is key to prevent performance differences from the benchmark.

Passive managers aim to run very low cash balances and to invest flows at the appropriate timing points. They can also use liquidity instruments such as futures and ETFs (exchange-traded funds), which are liquid and relatively cheap to trade, to manage cash flows. This keeps funds fully invested but also limits the number of trades, as each trade has a cost.

Typically, balances in liquidity instruments would range between 0 and 5%. This will vary depending on impact on tracking error, the potential divergence from the benchmark, and the cash flow trends in the funds.

Myth 5: Passive fund managers simply follow an index, ignoring other considerations

Passive funds experience costs, while indices ignore most costs. Passive fund managers therefore have to be smart in what they do and how they do it, constantly balancing the cost of trading with the risk of not exactly matching the underlying index.

This balance lies at the heart of passive fund management. A lot of the time passive managers are “running to stand still”, doing what they can to minimise costs and tracking error to ensure the fund closely matches the underlying benchmark returns. Programme trades can be used where possible to ensure commission rates are minimal, albeit managers must be cognisant of other trading costs such as stamp duty. Skilful passive managers only look to trade stocks and bonds when the risk of not doing so outweighs the costs associated with the trade.

Myth 6: Passive fund managers cannot add value against a benchmark

The number one objective for passive managers is tracking. It’s what they spend most of their time on, although some managers do try and add small amounts of outperformance where possible while limiting any risk against the benchmark.

An example would be scrip dividends, where companies offer the option to take the dividend as stock, instead of cash. Most indices assume the cash value of the companies’ dividend is reinvested in the underlying index on ex-date. But sometimes electing stock can be advantageous, as a result of market moves. In that case a manager would elect to take stock over cash. It’s also possible to sell the stock at the point of election to take up additional stock, ensuring that the advantage is locked in to the fund and that there is no unwanted risk against the index.

Stock lending can also add value, providing it is well governed and there are protective policies in place.

Passive managers don’t aim for 50bps of outperformance, but if they can add 2 or 3 basis points it helps to offset some of the costs incurred. In passive management every single basis point counts.

Why invest passively?

The above goes some way towards demystifying passive investing, and explaining what passive managers actually do. But what about the question of why? What’s it all for?

The answer is simple. Passive strategies offer clients easy, affordable access to a range of global, regional and local equity and fixed income markets. An allocation to a passive fund can provide exposure to hundreds of securities in the most cost-effective way.