BLOG - How passive funds work

Rob Davies, Fund Manager VT Maven Smart Dividend UK Fund

The debate around passive funds, also known as trackers, index or evidence based funds is getting gradually louder as evidenced by increasing comments in the traditional press and online. There are a lot of advocates for active management and not just in the fund management industry itself. It supports substantial activity in the media, conference sector and other areas.

Nevertheless, the evidence of increasing flows into passive funds is strong as more and more investors elect to go for the simple low cost strategy of getting exposure across the market rather than a selected sub-set of stocks which are traded on a regular basis. According to the IMA passive funds accounted for a record 10.9% of funds under management at November 2014. Instead of the excitement and risk of betting on one horse in a race punters are preferring the gentler and more predictable returns from investing in all of them.

Buying the whole market guarantees you will own the winner. It is perfectly true that it is possible to increase returns by committing the whole portfolio to the pre-race favourite but that massively increases the risk should something untoward occur.

However, there are other reasons passive funds can do well. One is that passive funds rarely sell.

Irrespective of how well a stock does a passive fund has no reason to sell it unless it leaves the index. That means it captures all the gains by not selling out too early. It doesn’t have to make the difficult decision of when to sell and potentially not maximise its return. Moreover, because passive funds never have a massive exposure to smaller stocks they won’t suffer unduly when a wonder stock starts to retrace its gains. It just means that another stock will take over as the best performer because, by owning the whole market, the fund is sure to own it. That contrasts with an active fund that is extremely unlikely to hold every best performing stock in a smaller, more focussed portfolio.

Another reason that a passive approach works is because a fund is always, in practical terms, fully invested. It does not try to time the market by taking a view on whether it is cheap or dear. Cash comes in and, as long as there is enough for liquidity purposes, is invested straightaway. That benefits investors in two ways.

First, it means they capture the full extent of every rally. They aren’t sitting on the side-lines waiting to see if it is going to last and thus losing out on part of the gain before committing cash. Critics say that means they suffer in the downturns too. Whilst that is true it still means that being fully invested all the time is an advantageous strategy because markets, in the long-term, go up more than they go down.

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. And right now yields on equities are also higher than interest on cash. The difference between being fully invested and holding, say, 5% in cash does not sound very much. But losing 5% of a 10% rally is the equivalent of suffering lower gross returns of 0.5% or, put another way, an extra 0.5% in costs.

It is widely recognised in the industry that it is time in the market that counts, not timing the market.

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