Saturday, 27 May 2017

    Passive investment: A jargon buster

    Confused by the language of passive equity investment? Let our jargon buster help.

    confused investor

    Active management – sometimes seen as the opposite to passive investment, although the two approaches can, and often are, combined in an investment portfolio. Active management is based on a fund manager’s skill, with the aim of delivering better returns than passive funds that simply track an index (see below). As active management is based on an individual’s skill, it is usually more expensive – but in theory at least, it should deliver better returns.

    Alternative Indexation/Smart Beta – the two terms are often used interchangeably. Alternative Indexation uses index-based funds as a starting point. As such, all of the shares in a given index are still held by the fund manager, but one or more factors (see below) are also applied, to determine the balance of shares from each company held by the fund. The aim is to improve returns without significantly increasing the amount of risk in the fund. By basing stock selection on criteria other than simple market capitalisation (see below), a smart beta strategy can deliver better returns. Alistair Byrne, senior DC strategist State Street Global Advisers says that pension schemes are showing increasing interest in smart beta “to enhance returns and minimise risks, but still within an index-tracking approach at relatively low cost.”

    Concentration risk – The FTSE 100 index, or any other market-based index, is likely to include several companies in the same sector. As a result, something that negatively affects that sector will affect all companies within it. For example, if fuel costs rise, it will affect every transportation company. This is termed ‘concentration risk’.

    Environmental Social and Governance (ESG). As pension trustees start to apply more scrutiny to how companies are run and the impact that has on the environment, ESG is becoming more important. To support that growing awareness, there are increasing numbers of ESG-related indices that fund managers can use as the basis for passive funds. For example, index builder MSCI has created indices based on both broad ESG principles, and on more specific ‘thematic’ elements, such as quality of corporate governance or low-carbon companies. Legal and General Investment Management is also following this trend. Its recently introduced Future World Fund has been adopted by HSBC’s pension scheme as its default fund. The fund is multi-factor (see factor-based investing below), but also applies a climate-related tilt (see ‘Tilt’, below), which gives the fund its name. “The story behind the fund is a world for the future, but it’s also about generating returns,” says Emma Douglas, head of DC solutions at LGIM.

    Exchange Traded Fund (ETF) – an exchange traded fund mimics the performance of an index (and contains passively-managed stocks from all the companies within that index), but it is traded like an individual share, so is comparatively easy to buy and sell. They are also priced on an ongoing basis during the day, rather than given a value at the beginning of each day. As such, they come into their own when taking advantage of short-term market trends. There is a huge variety of ETFs available, so they are also often used to get passive exposure to unusual or hard-to-reach markets.

    Factor-based investing – shares in an index are weighted using factor(s) that, over time, should generate better returns than simply investing in companies based on their market capitalisation. Some of the most commonly used are: value, size, low volatility, quality, momentum (taking advantage of companies that are doing well and likely to continue to do well in the short to medium term) – as well as multi-factor approaches, which combine several factors together within a single fund. “We are seeing more interest in alternatively weighted indices,” says Douglas of LGIM. “Factors such as low-volatility and size can be built into index investing. That gives the added value of a more active tilt, but still in an index fund.”

    Fundamental investing – This method uses measures unrelated to the size of a company, but that could affect its performance, to select which equities to invest in. Examples could include ESG (environmental, social and governance) performance (see above).

    Index – A collection of entities (for example equities), grouped together by a common theme, such as company size or industry sector. The FTSE 100 and 250 indices, for example, group companies based on their market capitalisation (see below).

    Liquidity - This refers to the ease with which an investor can buy or sell an asset. For example, property is generally illiquid, because it takes a long time to sell the asset and release the money held within it. Most passive investments are highly liquid.

    Market capitalisation indices – a lot of traditional passive investment funds are based around ‘market capitalisation’ indices, such as the FTSE 100 or FTSE 250. ‘Market capitalisation’ is the total market value of a company’s equities, achieved by multiplying the number of shares in the market, by the share price.

    Passive – also referred to as index tracking and beta. A passive equity fund selects shares based on a set of criteria, such as an index, and often the quantity or value of shares held in each company will also reflect its position in the index. There is no fund manager judgment involved in selecting how the fund is constructed.

    Real Estate Index Tracker (REIT). REITs invest in the shares of companies involved in property/real estate, such as builders and land managers. They are more liquid than investing directly in property, but are said to deliver some of the same investment characteristics over time.

    Replication – A fund closely tracks (or replicates) the index on which it is based. If Company X represents 10% of the total value of the FTSE 100, 10% of the value of the fund will be held in shares in Company X.

    Rebalancing – readjusting the allocation of equities (or other assets) within a fund. If the companies within an index change (for example if a company falls out of the FTSE 100), or if the weightings within the index change, a fund is rebalanced to ensure it’s still doing the job for which it was set up.

    Sampling – if an index is too big or complicated for a fund to hold shares in every company within it, a fund manager might use sampling as a means of selecting stocks. For example, if 20% of the index is made up of transportation companies, the fund manager might hold 20% of the fund’s shares in transportation-related stocks, but might not hold shares from every company in the index.

    Tilt – a passive (or index-tracker) fund is usually just comprised of shares in the companies within that index. However, a fund manager can choose to ‘tilt’ the fund in a particular direction based on a given characteristic, such as ESG performance. That could sometimes mean investing in a handful of companies outside the main index, or amending the percentage of the fund allocated to each company’s shares based on how well they perform against that characteristic.

    Tracker, or Index Tracker – a fund that invests in all the companies in a given index, such as the FTSE 100. As such, the performance of the fund is directly related to (i.e. tracks) the performance of that index.

    Tracking error - the difference between the performance of a tracker fund and the index that it’s following. If you are investing in a FTSE 100 tracker fund, you might expect it to perform in the same way as the index. However sometimes there can be (usually small) differences, often as a reflection of the volume of shares in each FTSE 100 company held within the fund.

    Readers' comments (1)

    • "... an exchange traded fund mimics the performance of an index ... "

      A depressingly common fallacy. Too bad to see it repeated in an article that claims to be reference material. Last time I looked, about 20% of ETFs were something besides index funds.

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