Passive (Index) Investing

What is “Passive Investing”?

Passive investing, also referred to as index investing or index tracking, is an investment strategy where the assets of a fund are invested in such as way as to mimic the performance of a designated index. Although there is no possibility of outperforming an index, as is the aim of active investing, passive investing avoids the risk of substantial underperformance against the index, something which is possible with an actively managed fund.

Passively managed funds tend to have lower management fees than actively managed funds and have grown in popularity as investors seek a way to invest in a whole market or sector through a single trade. As the popularity of passive investing has grown, so has the range of different indices published by index providers, allowing investors a low cost way of investing in specific sectors (for example energy or healthcare) or themes (such as value or ESG).

Portfolio Construction Approaches

There are three main ways in which a portfolio could be constructed to track an index: Full Replication; Optimization (or sampling), or; Synthetic Replication.

Under Full Replication, the fund invests in all of the securities of the index in the same weights as those securities are included in the index. This method reduces the risk of fund performance being out of line with the performance of the index (also referred to as a tracking error), but can result in high transaction fees due to the high number of individual assets that need to be traded.

Optimization, also known as sampling, involves the fund investing in a sample of securities from within the index which it is hoped will match the performance of the index. The securities selected for the sample are designed to match the fundamental characteristics of the index, such as sector weights, as well as risk characteristic, such as beta or duration for equity or bond portfolios respectively. Optimization is often more appropriate than full replication for indices that contain less liquid securities, where it may not be possible to purchase the underlying securities in sufficient volume at a fair price. However, since all of the securities of the index are not held, there is the risk of higher tracking error

The final way to invest passively is to do so synthetically, which involves using derivatives. The main benefit of synthetic replication is that the performance of the derivatives will be driven by the performance of the index, resulting in low tracking error. However, it may not always be clear which derivatives are being used or and who the counterparties of the derivatives are which reduces transparency for the investor. In addition, there is the risk that the counterparties of the derivatives may default, resulting in the fund not receiving payments that are due. This is referred to as counterparty risk and is not a problem for the full replication or optimization approaches, since the securities are owned by the fund.

These approaches are not mutually exclusive, and a passively managed fund may use a combination of these approaches or change approach over time.

Changes to Indices

Although most commonly referred to as passive investing, tracking the performance of an index does not simply involve the portfolio manager purchasing the necessary securities and waiting for the fund to generate the same performance as the index. This is because the components of indices change over time.

There are two main ways in which indices can change. Firstly, indices are reconstituted periodically to update the constituent securities within the index and, secondly, the constituents of an index may to be subject to a corporate action, an event that changes the securities themselves.

When an index is reconstituted, the index provider (who is responsible for setting the rules that the index is subject to) will update the list of securities that are included within an index and the weights that those securities have within the index. For example, the largest 500 companies in the US, which make up the constituents of the S&P500, change over time. The provider of this index, S&P Dow Jones, updates the constitutent companies that make up the index on a quarterly basis. Other indices may be updated anywhere from monthly to annually.

Corporate actions are events triggered by a company that alter their issued debt or equity. Examples include stock splits, rights offerings (or rights issues), and M&A activity. These events may change the number of shares or the value of shares and as such will impact how they are treated within the index.

In order for a passively managed fund to track an index the portfolio managers must have detailed knowledge of the index construction rules, both with regards to reconstitution and corporate actions, to allow them to reposition their portfolio in line with changes to the index itself.