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A thread on how I evaluate passive funds...
Why I am writing this: A new narrative is emerging that all passive funds are good and all active is bad, because passive is cheap and fund managers don’t generate alpha. While I don’t want to debate that, I only want to say, passive funds need to be evaluated too.
And the criteria to evaluate them are different from active funds, but they still exist. So laying down what I look at in passive funds. Disclaimer: my business is 50-50 active passive so I really can be objective here :)
1. The index
The whole and soul of passive investing is the index the fund tracks. There are good and bad indices and if your fund tracks a bad index you are doomed on day 1. A few things on indices to keep in mind...
The whole and soul of passive investing is the index the fund tracks. There are good and bad indices and if your fund tracks a bad index you are doomed on day 1. A few things on indices to keep in mind...
1a. The theme
Sounds obvious but what’s the theme. Some themes solve no investment purpose. Just because they are packaged in a passive fund doesn’t make them good. Always ask what purpose this fits in my portfolio.
Sounds obvious but what’s the theme. Some themes solve no investment purpose. Just because they are packaged in a passive fund doesn’t make them good. Always ask what purpose this fits in my portfolio.
1b. Number of stocks
I don’t like heavily concentrated funds. 10 stock themes scare me, active or passive because they are volatile. That said, a 250 stock small cap index is a almost impossible to replicate accurately in India (more of this in tracking difference below).
I don’t like heavily concentrated funds. 10 stock themes scare me, active or passive because they are volatile. That said, a 250 stock small cap index is a almost impossible to replicate accurately in India (more of this in tracking difference below).
1c. Rebalancing
Good indices rebalance at a regular frequency, so check this. Indices that don’t rebalance don’t update to reflect market realities (I have seen some!) You will get index data and criteria independently on the index providers website.
Good indices rebalance at a regular frequency, so check this. Indices that don’t rebalance don’t update to reflect market realities (I have seen some!) You will get index data and criteria independently on the index providers website.
1d. Smart beta and quant
Market cap indices like large and small are easy to check. Smart beta indices like value or quality or thematic funds need research on how index is built and weighted. In a healthcare index, what sectors and weights are present?
Market cap indices like large and small are easy to check. Smart beta indices like value or quality or thematic funds need research on how index is built and weighted. In a healthcare index, what sectors and weights are present?
1d. Smart beta and quant contd.
Understand how your index is built well in a smart beta or factor fund. On quant funds, these are NOT passive funds. They are model driven funds that are as active in how they trade as traditional active equity funds. Wrote a separate thread.
Understand how your index is built well in a smart beta or factor fund. On quant funds, these are NOT passive funds. They are model driven funds that are as active in how they trade as traditional active equity funds. Wrote a separate thread.
2. Tracking the index
Ok you like the index. Does your fund track it? How well. More than tracking error I like tracking difference, the difference between fund returns and index returns. Some is inevitable but this irons out over a long period of time.
Ok you like the index. Does your fund track it? How well. More than tracking error I like tracking difference, the difference between fund returns and index returns. Some is inevitable but this irons out over a long period of time.
2. Contd
Categories where tracking difference should be especially checked: international funds that replicate wide indices (and don’t buy an ETF abroad) and mid and small cap funds tracking wide 100-200 stock indices (because of liquidity).
Categories where tracking difference should be especially checked: international funds that replicate wide indices (and don’t buy an ETF abroad) and mid and small cap funds tracking wide 100-200 stock indices (because of liquidity).
3. Liquidity
Matters a huge deal. One is the liquidity of the underlying which we discussed above in context to mid and small cap funds. You want the index to have liquid securities. Also matters in segments like debt. You want debt indices that are liquid.
Matters a huge deal. One is the liquidity of the underlying which we discussed above in context to mid and small cap funds. You want the index to have liquid securities. Also matters in segments like debt. You want debt indices that are liquid.
3. Contd
The second is liquidity of the vehicle itself. Index funds have no issue here because they operate like MF. But with ETFs you have to factor spreads which are quite large with some ETFs. I generally like FoFs and index funds more (I don’t care for teal time NAV)
The second is liquidity of the vehicle itself. Index funds have no issue here because they operate like MF. But with ETFs you have to factor spreads which are quite large with some ETFs. I generally like FoFs and index funds more (I don’t care for teal time NAV)
4. Transparency
Passive funds are meant to be easy simple and transparent. Make sure your rules are clearly known, portfolios and index details clearly available, and fees well known. The standard on transparency should be higher than active funds here.
Passive funds are meant to be easy simple and transparent. Make sure your rules are clearly known, portfolios and index details clearly available, and fees well known. The standard on transparency should be higher than active funds here.
5. Fees
Of course you want low fees in a passive fund but do take into account total cost of ownership.
Index fund: TER
ETF: The expense ratio plus brokerage plus bid ask when you trade
FOF: Underlying ETF or fund fee and FoF fee
Plus any loads.
Of course you want low fees in a passive fund but do take into account total cost of ownership.
Index fund: TER
ETF: The expense ratio plus brokerage plus bid ask when you trade
FOF: Underlying ETF or fund fee and FoF fee
Plus any loads.
5. Contd
People often don’t take into account total costs of ownership. Remember you see index returns but earn index returns minus tracking difference minus costs.
People often don’t take into account total costs of ownership. Remember you see index returns but earn index returns minus tracking difference minus costs.
Finally passive or active are industry words. Buy good funds that solve your problems. And they can be passive or active or both. Happy investing!
