Indexed investments have long been considered safe for people with low risk tolerance.
While remaining passive, some new-generation products are set and forget solutions, such as low-volatility products with more diversified weightings that mitigate downside risk while providing capital appreciation exposure to capital markets. Other funds have both fixed-income and equity components while still following a passively managed strategy.
“The passively managed market is becoming more niche and solutions oriented. Because of this evolution, investors can now gain specific or broad investment exposure with a single purchase,” says Kevin Gopaul, SVP and chief investment officer, BMO Asset Management.
Mary Anne Wiley, managing director and head of iShares, BlackRock Canada, says retail investors: want to lower the risk and volatility of active management, but aren’t ready to go pure market-cap.
“Retail investors don’t want to go to full market replication, but have learned active investment is expensive and often disappointing.”
She adds, “Active managers for the most part don’t beat the market. These two forces are spawning growth in non-cap-weighted indices.”
In a low-return environment, low-cost products are taking off. Gopaul notes, however, that the evolution of passive investments puts the onus on advisors to stay on top of product rules as they evolve.
Larry Berman, CIO for ETF Capital Management, says if the index rules were created through back testing and optimization, “the fund may not be robust because the performance may have been optimized. That means future performance may not be replicated because it may have been very few adjustments that delivered the superior performance.”
He adds, “You’d have to read through the index methodology documents to know that, [which] may not be practical for the average investor. Advisors should also look at the performance over several market cycles. Does it outperform [its benchmark]?”
Dramatic over or underperformance is a sign of tracking error, and a poorly constructed fund (see “Tracking errors and rebalancing,” this page). But small errors can be justified, because “in an effort to cut fees, sampling techniques proxy the index,” says Berman.
If it’s an enhanced ETF (see “Alternatives can be better,”), you’d want to see outperformance over time.
Tracking errors and rebalancing
Cap-weighted index funds typically rebalance quarterly, while certain preferred shares indices rebalance semi-annually.
Most large index providers rebalance quarterly.
When this happens, the index manager implements the rebalanced strategy to continue to meet the rules of the index, based on the size and liquidity of the market, but the process is invisible to investors.
Mary Anne Wiley of iShares adds that rebalancing is often scheduled, so investors should know what to expect.
BMO’s Chief Investment Officer Kevin Gopaul adds that index funds should have low tracking errors.
An index fund manager rebalances the fund composition to maintain the replication rules. The capital gains and losses accrued due to the buys and sells are borne by the fund and affect the adjusted cost base.
A rebalanced fund will show a higher tracking error immediately after the transactions take place; and then, going forward, it should have a low tracking error. Index funds hedged for currency risk routinely show higher tracking error than non-hedged funds.
“Good index managers rebalance to match the index and minimize tracking error,” says Gopaul.
If you want to show clients the tracking errors of their ETFs, you’ll find them on the fund manufacturer’s website. They aren’t reported on client statements.
Lisa MacColl is an Ontario-based financial writer.