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

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.

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