We don’t support this browser anymore.
This means our website may not look and work as you would expect. Read more about browsers and how to update them here.

Skip to main content
  • Register
  • Help
  • Contact us

Man vs Machine – how do managers run a passive fund?

We take a deep dive into the reality of running passive funds and the decisive role of the portfolio manager.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

There’s a common misconception that passive funds are run by robots, whose function is to rebalance the portfolio holdings in line with the index it’s tracking. It makes sense. Why have a human to buy and sell investments when you could automate the process?

In reality, running a passive fund is far from smooth. A stock market index can’t and doesn’t take into account real trading issues like dealing costs or taxes. If left unchecked, these factors can leave a fund’s performance significantly trailing behind the index.

In steps the role of the portfolio manager.

A passive portfolio manager has the important role of keeping the tracking errors as low as possible. This helps the fund stay as close as possible to the benchmark it’s tracking. Tracking error is a result of those ‘real life’ trading problems and is a key consideration for the managers when analysing a fund’s daily performance.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. As with all investments, passive funds go up and down in value so investors can get back less than they originally invest.

A battle against tracking error

Passive, also known as tracker, funds aim to track the performance of a particular index, or stock market. Passive managers are in an ongoing battle with the index they’re trying to follow. An index is constantly changing, so managers need to react swiftly to re-adjust the fund.

Most will have access to systems which flag the current value for tracking error. This allows them to make alterations to the holdings and bring this value as close to zero as possible. They can even apply theoretical changes two weeks in advance to model the best outcome going forward.

How do portfolio managers reduce tracking error?

Managers can decide whether they opt for full or partial replication of a stock market index. A fully replicated fund holds all the shares or bonds in its index. It’s useful for stocks that can be traded easily.

Partially replicated funds instead aim to deliver the performance of the index without the cost of owning every single stock. This is particularly useful for funds that aim to always pay the same amount of income, where the benchmark they’re following might have thousands of holdings.

When buying and selling investments, fund managers also factor in ongoing corporate actions which could impact a share price. Their expertise and knowledge of the index feeds into their decision on when and how to trade around events like these.

If funds receive a large inflow of cash from buying units in the passive fund, managers can also buy derivatives. Derivatives replicate the performance of an index instead of the underlying investments.

This can be a more cost-effective way of mirroring the performance of an index without incurring the cost of buying every holding, again keeping tracking error lower.

These are just a handful of the tools at a manager’s disposal. In reality, they have a range of options available to tackle tracking error depending on the index they’re tracking and what’s happening with the underlying investments. There’s no one size fits all, and it’s down to the managers to employ what they believe is the best approach.

A view from the industry

We recently spoke to two experts in passive fund management who shared their views:

Raphael Stern, Global Head of Fixed Income, ETF & Indexed Strategies at Invesco:

"The human element is critical when managing passive funds. While automation is possible for many processes, the key task of a passive fund manager is to ensure that data and ultimately fund risk is accurate. This requires a systematic and detailed process to identify exceptions and then rectifying them.

While our process has embraced and leveraged technology and automation to a high degree, Passive Managers (PMs) monitor each ETF closely for: daily validations of key risk parameters against a strict set of limits, corporate actions and index events, order and trade and transaction costs.

Due to the nature of Fixed Income markets, most portfolios apply a sampling methodology rather than full replication. This implies the use of a mix of optimization as well as a hands-on PM approach to ensure the portfolios are aligned well for multiple risk factors, we control for all, whilst keeping transaction costs to a minimum. This is one key reason why the value-add of a passive fund manager is extremely high”.

Joseph Molloy, Head of the Index & Systematic Equity Portfolio Management team at HSBC:

“The type of passive product proliferation in recent times has been into areas such as ESG and thematic passive indexes. These areas tend to exhibit higher index turnover, have greater scrutiny on what exposures can be included, and touch areas of the stock market with less volume and liquidity - and therefore have potential for higher transaction costs.

When you consider that passive investing is expected to be low cost, the diligence and challenge that has to be met by human investment teams is greater, and - to date - automation can’t solve this adequately. This is a very different challenge to those previous ‘plain vanilla’ FTSE 100 or S&P 500 indexes where complexity is limited.

With greater complexity the shift in automation has tilted back more towards greater human input in the investment decision making process. That interaction could be: a) how to solve liquidity challenges in the portfolio construction phase. b) how data is integrated and interpreted in an ESG fund. Or c) how real time market events unfold (such as the start of the COVID-19 pandemic)”.

What this means for investors

Look under the bonnet of a passive fund and you’ll find there’s always more going on than first meets the eye.

An index-tracker fund is one of the simplest ways to invest, and we think these funds could be a great, low-cost starting point for a portfolio aiming to deliver long-term growth. They could help diversify a portfolio focusing on active managers or individual shares and bonds.

Passive funds usually come with a lower fee as managers aren’t actively selecting investments to outperform the benchmark they’re following. However, there’s skill in running a passive fund, and the ability to reduce tracking error is key to ensuring investors returns match the returns of the index as closely as possible.

For investors interested in passive funds, the Wealth Shortlist has a selection of funds selected by our analysts for their long-term performance potential.

The Wealth Shortlist includes funds across a range of sectors, and risk levels that won’t be right for everyone – it isn’t personal advice.

Fund insight: our weekly email

Sign up to receive our expert fund research and insights.

Please correct the following errors before you continue:

    Existing client? Please log in to your account to automatically fill in the details below.

    This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.

    Loading

    Your postcode ends:

    Not your postcode? Enter your full address.

    Loading

    Hargreaves Lansdown PLC group companies will usually send you further information by post and/or email about our products and services. If you would prefer not to receive this, please do let us know. We will not sell or trade your personal data.

    What did you think of this article?

    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

    Editor's choice – our weekly email

    Sign up to receive the week's top investment stories from Hargreaves Lansdown. Including:

    • Latest comment on economies and markets
    • Expert investment research
    • Financial planning tips
    Sign up

    Related articles

    Category: Funds

    HL Select turns 7 – what we’ve learned and what’s next

    HL Select Fund Manager Steve Clayton looks back on seven years of the HL Select fund range, how it’s performed and what’s next.

    Steve Clayton

    01 Dec 2023 6 min read

    Category: Shares

    Autumn statement 2023 – NatWest retail share offer

    The UK government could sell its NatWest shares to the public by the end of 2026. We look at how this could work and how you can stay up to date.

    Jason Roberts

    29 Nov 2023 4 min read

    Category: Funds

    Mixed and total return sector review – mixed economic data and peak rates

    We look at what’s been happening in the world, the impacts of this on shares and bonds and how mixed investment and total return sector funds have performed.

    Hal Cook

    28 Nov 2023 6 min read

    Category: Funds

    How to invest in China – 3 fund ideas

    In our latest deep-dive into China, we look at three fund ideas to gain exposure to the Chinese economy and stock market.

    Henry Ince

    27 Nov 2023 6 min read