What exactly is an index tracking or passive fund?

Monday, Mar 09 2015 by

Trying to describe a passive, index or tracker fund is a lot harder than it might seem. Take a look at some excerpts from descriptions, by the managers, of a number of funds that are widely regarded as falling into this category.

“… closely matching the performance of the FT-SE Actuaries All-Share Index. The Authorised Corporate Director (ACD) will aim to hold securities that represent the FT-SE Actuaries All-Share Index “
“Generally the Fund intends to purchase a broad and diverse group of readily marketable stocks of United Kingdom companies traded principally….”
“To closely match the performance of the FTSE1 actuaries All-Share Index on a capital only and total return (after charges) basis.”
“xxxxx FTSE U.K. All Share Index Unit seeks to track the performance of the index”
“ aims to provide long term capital growth by matching the return of the FTSE All-Share Index by investing in….””

And so on……

Two things stand out. They use words like aim, closely and seek, and they fail to describe exactly how they intend to achieve their objectives.

It is clear that none of these funds expects to exactly match the index they are tracking. That is because of factors such as new issues, takeovers and holding un-invested cash or perhaps lack of liquidity with some of the small stocks near the bottom of their respective indices. These complexities mean that the managers must exercise at least a modest degree of subjectivity to address these points and maybe use derivatives to help out.

More important though is how these funds are managed. It is clearly not the case that they just buy the index and leave the market to do the rest. At the heart of this matter is the differentiation between the process and the measure. The process is to invest using a set of rules that could be interpreted by any qualified finance professional, rather than a feeling in someone’s water. That is the passive investing process.

Since it started in the mid-seventies the default assumption is that passive means allocating capital according to the market capitalisation (mkt cap) of a company in relation to that of the index as a whole. In other words the measure used to allocate capital to a company in the index is the price of that company. This made sense in the early days of indexing when company accounts were rudimentary by today’s standards. Modern financial statements are far more detailed and enable analysts to get a much more thorough understanding of the company. Even so there are essentially only four ways to fundamentally measure the size of a company; by sales, by book value, by dividends and by profits.

Some argue that weighting based on mkt cap is the only true way to run a passive fund because it uses the same measure as the index and is therefore the only mechanism that permits fluctuations in the market to be reflected in the fund without any dealing activity. Managers who advocate using other measures would counter that this confuses the process with the measure.

Investors might wonder why there is a need to use any measure other than mkt cap for a passive fund. After all a passive fund will hold all, or virtually all of an index. The question is in what proportion? Here, Oscar Wilde’s famous quip that “nowadays people know the price of everything and the value of nothing” seems relevant to mkt cap based funds.

Using a value-based fundamental, rather than a price-based, measure to allocate capital does not invalidate the passive process and, arguably, provides the only possibility for a truly passive approach to beat the market. It just does it in a different way. It is perfectly possible to allocate capital by any one of these five measures in a passive manner i.e. following a strict rules based process. There is plenty of evidence, from Warren Buffet downwards, to tell us that portfolios with a bias to value do better over the long terms. That makes sense as essentially managers are investing in anticipation of a stream of earnings and, as with everything in life, buying something cheaply usually gives a better return on that capital.

A passive fund is simply one that follows a process, regardless of how it is defined, and irrespective of the measure employed, to invest in all, or the majority, of the constituents of an index with the absolute minimum amount of subjectivity.



Past performance is not a guide to future returns. The value of investments and the income from them may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. For risks relating to specific products, please refer to the relevant documentation for that product.

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7 Posts on this Thread show/hide all

Edward Croft 9th Mar '15 1 of 7

I'm not a fan of any of the index-weighting schemes that are currently popular. It seems to me that they are all designed for the benefit of the fund provider, not the investors in the fund.  i.e. they are designed to scale and make the running of the fund profitable for the vendor.

Market Cap or Fundamentally weighted indices are lower cost than equal weighted funds, but provide FAR less exposure to the underlying driving factors behind share performance.

Great research by SocGen shows precisely this  ... the blue line below shows equal weighted portfolios of stocks (of different cheapness) versus Market Cap weighted portfolios.   No question which wins - equal weighted hands down beats cap weighted.


Private investors are best placed to profit from the value anomaly (and the other anomalies) in the market... just not via ETFs or index funds or smart beta funds... by building their own directly invested portfolios using simple stock selection techniques, equal weighting and diversifying wisely.  There's just no point mucking about in funds unless you desperately want to subsidise someone else's Porsche Cayenne.

DYOR etc.

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pka 9th Mar '15 2 of 7

Ed, I don't disagree with your arguments and conclusions. However, that graph from SocGen is a wonderful example of what a little book I read many years ago called "How to Lie With Statistics" explained of how newspaper articles and advertisers often use graphs to give very misleading visual impressions of statistical arguments. By truncating the vertical axis at 6.0, rather than starting it at 0,0, the graph greatly exaggerates the relative advantage of equal weighting over MCAP weighting.

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Blissgull 9th Mar '15 3 of 7

To be fair comparing Stockopedia's equally weighted guru screens or Stockranks performance with market weighted FTSE indexes is doing the same.

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dangersimpson 9th Mar '15 4 of 7

Fundamental indexing is mathematically identical to market cap indexing and applying a value tilt (in whatever form you choose, e.g. fundamentally indexing by dividends applies a yield based tilt, earnings a P/E, revenues a P/S etc.)

Asness discusses this in a recent Master's in Business Podcast on Bloomberg (from 1:04 onwards although the whole thing is well worth listening to.)

Equal weighting is mathematically identical to market cap indexing and applying a small cap tilt.

Apply value or small cap tilts like these strategies do often gets tagged with the name 'smart beta' these days.

But since each return factor is mostly independent then there is no reason why you should only apply one factor. A well constructed small cap value portfolio with quality filters (see asness recent paper http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2553889) should easily beat both randomly selected equal weighted portfolios and fundamental indexing over the long term.

A passive equal or fundamentally weighted index is better than market cap index but not better than a passive strategy that gains access to more than one expected return factor. If you are going to go passive and you believe the returns to 'smart beta' outweigh the costs why settle for less excess return than is available?

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pka 10th Mar '15 5 of 7

A major issue with equal weighting strategies is deciding from which universe of stocks an equal weighted portfolio should be selected from. For example, an equal weighted portfolio of, say, 30 stocks with high Price to Book ratios that is selected from stocks in the FTSE All Share Index would probably perform very differently from a similar portfolio selected from stocks in the FTSE 100 Index. The portfolio that would perform better would probably depend on whether large or small companies were doing better at the time. But the performance of the FTSE All Share Index itself tends to stay fairly close to that of the FTSE 100 Index, because they are both market capitalisation weighted indices whose performances are dominated by those of their largest constituents.

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JollyBiologist 10th Mar '15 6 of 7

In reply to post #94075

Hi Ed,
I'm very very anxious NOT to subsidise anyone's Porsche Cayenne, but I thought that was the great advantage of trackers, that their low fees meant a)you're not being ripped off my outrageous management feeds and b) it outperforms any managed fund over a significant period (see Investors Chronicle, Motley Fool, etc etc). Have I got this all wrong? I must admit I don't fully understand the arguments you lay out, but then I don't fully understand my tracker statement, nor Henderson's explanation of why they can't provide a break down of their fees on the statement!

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Rob Davies 10th Mar '15 7 of 7

Research by Morningstar, which is no fan of passive funds, has shown that the most reliable predictor of future returns is the cost of running a portfolio. With the current level of charges, and the ability to go direct to the manager in small sizes and thus avoid brokerage costs, private investors would find it hard to run similar portfolios at similar costs.
Few people claim that passive funds are an elegant solution to delivering the returns of the asset class. But history demonstrates that the wealth of knowledge, in part from sites like this, makes it very hard for any smart manager to consistently beat his competitors, who are also smart. Collectively, all the investors must deliever the returns of the market. That is not to say you cannot beat the martet; of course some can. The question then becomes whether the time and cost required to do so is returned by outperformance

It also means that the market beating returns in the good years have to be high enough to overcome the drag from years when the investor does not beat the market.
However, that was not the point of the blog, which was to say that passive funds have a degree of subjectivity that many of them would prefer to downplay.
That means there is a grey area between passive funds and active funds that use a very thorough and tightly defined investment process.

Fund Management: VT Smart Dividend UK Fund
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