A problem with index tracker funds, part 2

A problem with index tracker funds, part 2

Image by Lorenzo Cafaro from Pixabay 

Further to my blog from two weeks ago there are other potential issues to consider when using index-tracker funds.  However, as I said before, in most cases an index tracker fund makes sense versus an actively managed fund, at least that’s what the evidence is telling us, but that doesn’t mean that index-tracker funds don’t also have their issues.

As we know most ETFs and tracker funds aim to replicate the performance of a basket of securities by referencing an ‘official’ index like the many published indices we see being quoted and compared against.

There is however a potential problem with most of the official indices in that they include many securities which either dilute or skew the return of the required asset class.  Take for instance the FTSE All Share, which includes investment companies and utilities.  Investment companies invest in other companies and so represent a dilution of the asset class.  Utilities, on the other hand, are highly regulated and as such skew the exposure to what is, in effect, a value type company but with constraints on its profits.

Another potential issue occurs when a company is first listed on a stock market, as its initial listing value is determined by the sponsoring investment bank and broker based on what they think the market will pay for the shares.  Several pieces of research suggest that most initial public offerings (IPOs) go on to experience relatively poor performance over the first five years or so.  Clearly some companies experience price rises after they are listed but some don’t.  Traditional index funds and ETFs must buy into these new IPOs as they enter the index, causing them to buy shares that more often than not will experience a decline in value while investors determine the true market value.

Other companies which make up the index can be in extreme financial distress and might be near to receivership.  Until the shares are suspended an index manager is compelled to buy shares in that company in proportion to the index, even if it’s evident that the company is in a dire financial condition.

It’s also worth considering that stock market indices aren’t designed as an optimal investment proposition (the first index funds only appeared in the early 1970s, long after indices were introduced).  Consequently some indices are less useful than others when it comes to representing the market they measure.  The levels of the US Dow Jones Industrial Average and the Japanese Nikkei 225 Index, for example, are determined solely by the prices of the constituents, so a movement in a single security can give rise to a large index movement; the market capitalisation of the constituents is not considered.

You should also determine if the fund uses a method to obtain the index return that you’re happy with.  There are three main ways that funds can obtain the index return: full replication; stratified sampling and synthetic/‘swaps’.

Full replication is where the manager chooses an appropriate index e.g. the MSCI UK All Cap Index and then buys all the underlying holdings that make up that index in as near to the same proportions as the index as possible.  Consequently this method is mostly used to track the largest and most liquid markets.  Full replication usually generates relatively high trading costs (dealing commissions and the spread between buying and selling prices) and market impact costs (the tendency of prices to move against the investor when they place large trades).

Stratified sampling is where the manager uses a sophisticated computer program to buy a range of holdings which represent a reasonable proxy for the index being followed and which can be expected to exhibit almost the same risk and reward characteristics.  This approach usually gives the manager more flexibility on what is bought and sold (thus reducing market impact costs) and should also have lower explicit costs than full replication.  It does, however, also have a higher likelihood of having performance which is different from the index that it’s seeking to track, as the portfolio itself will differ from the index.

Synthetic or swap-based replication is where the fund manager uses ‘swaps’ or other derivatives to obtain exposure to the chosen asset class, rather than physically buying the underlying investments.  Since the fund manager doesn’t own the actual investments, rather a contractual undertaking from a third party (such as an investment bank) to provide the return of the asset and some security in the form of other assets from the bank, this introduces counterparty and collateral risk.  If the counterparty fails, then the swap is likely to be worthless and the premium paid by the fund manager for the asset class return will have been lost.

In a swap arrangement the manager gives the fund’s assets to an institution which undertakes to deliver the index return on those assets.  In exchange, the fund manager takes security over other assets of at least equal value that are owned by that institution.  Sometimes, the assets pledged as security can be illiquid and this can introduce additional problems if a large number of investors want to liquidate their holdings and the fund manager has to step in as market maker to facilitate this.

Funds (usually ETFs) which use ‘synthetic replication’ may, therefore, represent a higher risk than physical replication in that they rely on the financial security of the various participating investment banks and their ability to honour their obligations associated with the ‘swaps’ or derivatives contract as well as the type and basis of any collateral security provided.

In my last blog I suggested that a solution to the issues of Index-Tracker funds is to use ‘pure asset class’ funds that don’t have an objective of following a published index, but instead have a flexible approach over which holdings they might include, led by their own definition of the asset class it’s investing in.  The manager can then have a flexible trading policy which doesn’t force them to buy or sell specific securities on set days.  These are predominantly the type of funds we include in our portfolios and, where possible, can be considered alongside index-tracker funds.

Cheers

Charles

This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.  Your capital is at risk when investing.  Past performance is not a reliable indicator of future results.