April 2012
How to choose a passive fund - www.smart-beta.co.uk
Part of the process of growing up is realising that the people you trusted more than anyone else in the world lied to you regularly, consistently and for a very long time. No one lies more than parents do to their children. It starts off innocently enough. First they tell them that Father Christmas will give them lots of presents then they promise visits from the Tooth Fairy. Later on it becomes the promise of borrowing Dad’s car if you pass your exams.
By the time the child has grown into adulthood he or she is pretty cynical about most things. But there is one great fiction they can hang on to. Out there, in the gleaming spires of London town, or maybe Canary Wharf, there is someone who actually understands capital markets. Even better, this mysterious person can not only comprehend what has just happened but is poised to make a killing from the next large, and unforeseen by everyone except him, movement in multifarious assets.
He is the Alpha Man that can beat the markets with a single bound.
Alas, the grown up now has one last disappointment to face. Middle aged, with a mortgage, two kids of his own to deceive to and faced with just a few years in retirement between leaving work and being moved into a care home he now realises that:
There Is No Alpha; just risk and luck.
Like the child learning that Mum and Dad actually bought him Buzz Lightyear and not Father Christmas he resigns himself to life as it is, not what he would like it to be. So he becomes a passive investor. But far from being a simple exercise the process of selection is actually quite difficult. What is the difference between an AMC and a TER and why doesn’t a TER include all the costs like dealing? And who gets the revenue from stock lending; does he or the fund manager? And what are the risks of the fund lending out shares it owns to a hedge fund? Does he really benefit if that trader then sells them short and trashes the value?
Corporate governance is becoming more important these days. Do passive funds just sit, well passively, as big companies run themselves as they like without any oversight from the providers of the capital?
Which index does he track? And why has the FTSE 250 done so well over the last four years when it consists of unpronounceable foreign sounding stocks doing things in countries that didn’t even exist when he was at school. All he wants is exposure to large, solid companies like GlaxoSmithKline, Shell and Vodafone.
And then there are ETFs. Why do some of them have turnovers of 100% when they are supposed to be such simple vehicles? Besides, what does it means when an ETF trades in “financial instruments” when all he wants is a simple thing that holds all the shares in the index and trades as little as possible. Having made a selection based on advertised costs the aspiring pensioner then feels excluded when some funds won’t accept investments of less than £100,000. And they charge 0.5% up front after promoting themselves as low cost.
One more thing might concern the investor actively seeking the best passive fund. Does it really make sense to allocate money on the basis of price alone? After all, when he is told to get the vegetables at the weekend he doesn’t buy more asparagus than potatoes simply because they are more expensive. Yet that is what most passive funds do. New money coming in is allocated to the largest company by price, not by value. Doesn’t that just create a bubble as we saw in the dot com boom?
These questions, and many more, will be asked more frequently this year as two big changes to the investing world arrive in 2012. One is auto-enrolment for pensions starting in October and the other is the run up to the implementation of the Retail Distribution Review (RDR) in January 2013.
Both of these events will increase the responsibility of investors to understand funds that will be so important to their future, whether active or passive. Those who still believe in Father Christmas and seek active funds will have a tough challenge despite all the advice in the press. However, the task is not easy even for those savers just looking for passive funds. These funds are sometimes referred to as beta funds because they aim to deliver the return of the index, which is known as beta.
To help this group Fundamental Tracker has built a website that aims to provide more information on beta funds. It also includes data on so-called smart-beta funds. These are funds that use tightly defined processes that aim to deliver the returns of an index in a better way than conventional market capitalisation, or price, based funds.
The data is not exhaustive and some of the information is incomplete or not available. But it may form a starting point for those who are desperately seeking beta; the market return at the lowest risk.