How passive funds work


#1

The debate around passive funds, also known as trackers, index or evidence based funds is getting gradually louder as evidenced by increasing comments
[See the full post at: How passive funds work]


#2

You say

Buying the whole market guarantees you will own the winner.
Well of course it does, just as buying every lottery ticket means you've got the winner, though it's an expensive exercise.

It also means you’re buying every loser.

Whilst I agree that there are lots of really bad actively managed funds out there there are also lots of really good ones who over time thrash the performance of Trackers.

I’d much rather be invested in one of these than in a tracker fund or ETF tracker.


#3

I agree with @malcolm but also @robert-davies says that by buying a Tracker you avoid smaller companies, but over the long term they perform better than larger companies, just look at the Numis index for evidence of that.

I am not against owning trackers and in fact I have an American tracker but as well as their advantages they come with disadvantages too.

The tracker fund that you manage succeeds in paying a very high dividend and for that reason for people needing an income it should have a look at it but I don’t myself like to just blanket buy trackers funds for every area of the stock market.


#4

Malcolm,

You say buy a good active fund but how do you know in advance which one?

Andre,

Trackers do hold small companies, but have small hold holdings in them. Unlike some funds they don’t have large holdings in small companies and that reduces risk.

In fact the main source of returns over the long-term is dividends, not capital growth, whether from large or small companies.

 


#5
The second advantage of full investment is a direct result of the unrelenting arithmetic of compound interest working through the mechanics of reinvesting dividends. That means that even when share prices are flat or falling a passive fund gets maximum benefit from dividend income and the compound returns it provides
Really? So you offer only accumulation units and not income units then? Does dividend income received by your fund immediately get re-invested, and in the event of a fall in share prices, assets then have to be sold at a loss to pay out a dividend due to your investors? If a passive fund can benefit from compounding in this manner then so can an active fund.
That means it captures all the gains by not selling out too early
That also means it captures all the falls by not selling out early enough. However, whilst this might be true for market-cap weighted portfolios, it isn't necessarily going to be true for smart beta products. Take, for instance, those based upon analysts' estimates of future dividends. By the time that these estimates have been revised then the news that caused the revision is likely to have caused the relevant share price to have already reacted to the news. And then the passive fund has to wait until the next index re-balancing date before changing its allocation.

@Malcolm, you are correct: a tracker buys all of the losers too - and in the case of Robert Davis’ fund, rather more of the losers than winners by the looks of things:


That’s compared to both the average active fund and a competing smart beta strategy also based upon forecast dividends.
The performance of Berkshire Hathaway over the years shows that the ‘dividends are the major source of returns’ argument is a spurious one. A dividend paid out leads to a reduction in a company’s capital, and a reduction in the share price, whereas a dividend retained does not. A dividend paid out where the investor re-invests merely buys a bit more of the same income-generating capacity. A dividend retained - or partially retained - allows good company management to increase that income-generating capacity which should lead to a faster rate of dividend increase over the years. So the smarter strategy ought to be to invest in companies with the best cash generative records and not just those that deplete their capacity by paying it out.


#6

There are a lot of fund managers out there as we all know who hug their index, so they’re quasi trackers but charge large management fees. In the most part I try to avoid them, though no always. City of London investment trust has tracker fund like charges of only 0.35% and for that you get the piece of mind of a bit of active management, it does hug the index a little but it pays me a great big dividend too.

The Maven fund is something I may consider when I retire ( which is painfully not that far away). I won’t be going for an annuity, I’ll be looking for a diverse source of income from a number of different funds/Bonds/investment trusts. As I will require income, capital growth will not be my primary concern (though I wonder how it would have performed if you had re-invested the dividends).

Until I reach retirement however it’s not for me.

Incidentally, the Vanguard fund in @arkwelder’s chart is looking none too shabby.


#7

I choose my funds/investment trusts @robert-davies by looking at past performance. A lot of nonsense is spouted about past performance is no guide to future performance - well it ruddy well is but I’m not talking about one year, or three year performance figures, I like to go back as far as there is data.

It’s no guarantee of course but it’s a great guide. Once I’ve found goof long term performance I look at how it’s delivered - borrowing/risk taking/fees. I look at managers holding and then consider if there investment style is still relevant. Finally I look at how cheap or dear it is and then I buy or not.

@ArkWelder’s point about reinvesting dividends is well illustrated by a chart I’ve seen published on this website several times…

Scottish Widows UK FINANCIAL HISTORY 1950 – 2013

 

 


#8

Ark,

The fund has income units. The accumulation units reinvest the dividends every quarter as they are distributed. The dividends are paid from income not capital so changes in share prices have no effect on the distribution.

You can compare the yields on the funds you mention here

and select the prices and yield tab.

 

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#9

Tracker funds buy everything so not just the winner, they buy the losers too. Sometimes that’s ok and sometimes it’s not.

I think that over the long term if you aren’t too interested in investing a tracker fund might be suitable for you.

Have you seen the article on the Blackrock 2015 predictions? It states that if the four biggest energy companies in the FTSE index had done nothing in 2014 the index would have been 250 points higher. If you had a tracker fudn you would had to had owned that it it was a FTSE tracker.

I prefer doing some homework are carefully choosing funds managed by a fund manager.

The article link is here: http://whichinvestmenttrust.com/three-quarters-ftse-100-shares-2014-whats-store-2015/


#10

The arithemetic is interesting here. If you own the best performer it gradually becomes a larger and larger part of your portfolio thereby compounding its importance to returns.

On the other hand a weak performer becomes less and less significant as it shrinks as a percentage of the portfolio.

That is why owning the good ones is more important than dodging the bad ones.


#11

Whether a performer of any kind becomes less or more significant depends upon the starting position.

The strongest performer could have originally formed just a tiny holding, and the weakest performer formed a more substantial one. So the performance of the strongest could have a relatively insignificant impact upon returns, whereas the weakest performer would have quite a significant impact upon them.

This applies for both active and passive strategies.


#12

Andre says small caps do better over the long-term but this research challenges that view.

 

Rob

 


#13

From the article:

Small stocks outperform large stocks in this sample [Table 2], but, because small stocks are generally more volatile, the Sharpe ratios reveal that small-cap investing provides a miniscule advantage in the risk-adjusted return.
So the argument appears to be that the risk-adjusted returns are where there is little to be gained from holding small caps rather than that they don't outperform per se.

 

The main issue with references to any type of return is the starting point and its presentation. Investors in small caps over the last decade will have a different perspective to the average returns since 1926. And averages themseslves are a problem because they mask both extremes and trends within data. As an example, the article states that since 1926, the average volatility of small caps has been higher than large caps. However, data from FTSE shows that not only have small caps outperformed on an annualised basis over 3 and 5 years, their volatility has been lower too: http://www.ftse.com/Analytics/FactSheets/Home/DownloadSingleIssue?issueName=ASX

I remember quite well that small caps in the 1990s tended to be serial underperformers when compared to larger caps. But since the market trough in 2003, small caps have tended to outperform on the way up, but underperform on the way down:

That graph (courtesy of Trustnet’s data) removes one of the ‘myth’ biases, namely transaction costs, because the small cap performance is that of the average fund performance - net of costs - versus the zero-charges returns of the FTSE 100.

 

Where the de-listing bias is not clear is what happens when large caps ‘de-list’ into being a smaller cap and join that index instead. Similarly, does the performance of a small cap that grows into a large cap still accrue to the smaller-cap index? Or does its outperformance then contribute to the large-cap index instead? Probably not, because a snapshot of the companies in the relevant indices in 1926 will be irrelevant (or, less relevant…?) to anyone that began investing at a (substatntially) later date.

 

Just as with Growth vs. Value, Small vs. Large will favour one approach at one time and the other later on.

If anything, the conclusion that I draw from the article is that when investing in small caps, it is best to avoid passive cap-weighted strategies.

 


#14

Ark,

You are right that a mkt cap weighting for a small cap passive might not be the best.

I suspect dividends would also not be good because many do not pay them. A similar argument applies to profits so that leaves revenue and book value. Neither are ideal, but they would work. You would just have to wait ten years to see which was best.

A weighting based on revenue would give a bias to growth while one based on NAV would be biased to value.


#15

Which definition of ‘smaller company’ are you using? If AIM is included then I’ll agree that a good many of them have no yield or profits. However, a quick look down Digitallook shows that a majority of Fledgling and Smaller Companies companies are making a profit and have a yield - but not nexeccarily both.

Consider your own fund, which has around 300 holdings. Using the Numis Smaller Companies Index as a definition of ‘smaller company’ , your own fund holds smaller companies, because the NSCI represents the bottom 10% of the market, and that means just the top 180-190 companies are excluded from this index.

‘One-third in smaller companies’ - do I get commission on your new marketing slogan…? :stuck_out_tongue:

Also note that there are funds that already have ten-year records so it is already possible to see how they have performed over different periods.

 


#16

I would use the FTSE Small Cap Index as the universe. The fund I run only has 200 stocks all drawn from the FTSE 350.

Including AIM stocks might be problematic because some of them have so little that is measurable.


#17

I have a holding in Gervais Williams Diverse Income. His big investment theme is dividend paying small caps that are he describes as being in a secular bull market that will run for years.

He doesn’t just invest in small caps but it’s his biggest theme. Besides this some of my top performing investments include Henderson Opportunities trust (smaller companies) and Standard Life smaller companies.

I think smaller company investing is where fund managers can outperform easier because they’re under researched, there’s more cheap/mispriced stocks as a result and it’s easier for a company to grow from £50m or £100m to become a billion pound company than it is for large or mega caps to grow anything like as much.


#18

Rubin,

Have these funds outperformed the Small Cap Index or just the wider market?

Rob

 


#19

As with anything, relative performance depends upon the period being measured. For instance, over the past 12 months SLS has underperformed both the FTSE All Share and Smaller Companices indices and DIVI is more-or-less equal with them. Since DIVI was launced it has comfortably outperfomed both indices, and SLS is in line with the All Share but lower than the Small Cap index - that, however, being down to its performace over the last 12 months.

Anyone that has owned SLS for 10 years will wonder what all the fuss is about because it has trounced both indices four fold. Owning for either 15 or 16 years will have resulted in either under or out performance.

All figures total return using Trustnet charting tool. What the above does not tell anyone is the actual journey of either fund or index - a problem when merely quoting returns, either as at the end of the term or as yearly averages.


#20

I believe that one year performance data is interesting but tells you very little. I invest for the long term and I don’t sell unless it really was a very bad idea.

Standard life Smaller Companies trust has been enormously profitable for me @robert-davies, whereas Diverse Income is new and whilst it’s been profitable it’s really too soon to judge but I’m fairly confident I’ll own it for many years to come. I think Gervais Williams is a great manager.

I take your point @arkwelder about when you buy. How I do it is I know I’m not clever enough to know when the stock market is at the top or at bottom, I just look for reasonable value, not the cheapest, or the dearest and hold it for a long time.

With Diverse Income I’m putting money in monthly but Standard Life was two lump sums.