INDEX-TRACKING IN DETAIL.

INDEX-TRACKING IN DETAIL TRANSCRIPT

First published on 3 November 2010 as part of our Smart Investment Month in association with the Telegraph.

NIKI CHESWORTH: 'Passive investing' doesn’t sound very exciting, but index tracker funds or 'passive' funds, form part of many of our investment portfolios. But do we really know how they work? I’ve got two gentlemen here from Legal & General: Simon Ellis, MD of Legal & General Investments—welcome; and Julian Harding, who is Director of Index Tracker Funds. Now, firstly, can you explain what is an index and what is a tracker, and how do they combine?

JULIAN HARDING: Sure. An index is a collection of shares or bonds that represent a particular part of the market or sector. They form the basis for constructing index-tracking funds, whose objective is to track the aggregate performance of the shares or bonds that make up that particular index.

NIKI CHESWORTH: So it could be like the FTSE 100, you would track the shares in the FTSE 100?

JULIAN HARDING: Yes, that’s a good example of UK listed shares.

NIKI CHESWORTH: So why would you just want to track an index passively rather than go for the opportunity perhaps to outperform it – what are the benefits?

JULIAN HARDING: If you look at an index-tracking fund, it gives you broad diversified exposure to a particular market. It doesn’t involve the requirement for expensive analytics to form the basis for active management, and therefore it has lower fund management costs. Also because of the passive nature of index-tracking there’s lower turnover within the portfolios, and so therefore on an ongoing basis there’s lower cost. Effectively it’s giving you a return consistent with that of the market.

NIKI CHESWORTH: And at a lower price?

JULIAN HARDING: Correct.

NIKI CHESWORTH: So Julian, can you tell us a bit about the history of index-tracking?

JULIAN HARDING: Yes. Investment indices have been in existence since the early 20th century. In fact, the Dow Jones Industrial Average has been in existence for over 100 years now. These early indices were very simple in their construction and were not designed for building investment portfolios but were designed to give the readers of the financial press an indication on average how share prices had moved over the previous day.

It wasn’t until the latter part of the 20th century that indices had developed to the extent that they could actually accurately describe particular parts of the market or sectors. And when this happened, these were used as benchmarks for actively managed funds.
The observation was then made that a number of active fund managers struggled to produce returns that were ahead of the index. This, in combination with it being very difficult to select those fund managers and funds which in advance are going to produce returns ahead of the index, meant that in the latter part, the last quarter of the 20th century, indices were increasingly used as the basis for constructing both equity and bond index-tracking funds.

NIKI CHESWORTH: We know from the Investment Management Association statistics that index-trackers account for a significant proportion of investors’ funds. So what makes them so attractive and popular? Simon, could you enlighten us, please?

SIMON ELLIS: Yes, sure. I think there are two primary reasons. The first is that many investors are trying to just replicate what the market’s doing: and so they’re saying, “I want to see what the UK is or US,” and they’re following the index itself. And the second thing is, as Julian said, that index funds tend to be cheaper than active funds.

NIKI CHESWORTH: And you say they’re replicating an index. I mean, we know about perhaps FTSE trackers. What other things can you track?

SIMON ELLIS: There’s a whole range of different indices: so you can cover different markets, you can cover different sectors. For example, there are funds that cover global technology, healthcare. It’s really a way of getting exposure to a particular investment theme or market that you’re attracted to.

NIKI CHESWORTH: So that all sounds quite simple really, but I’m sure it’s not, because there must be an art to tracking an actual index and ensuring the fund actually does what it says on the tin. So how can it be passive and yet match an index? Julian, can you explain first of all what you mean exactly by 'passive investing'?

JULIAN HARDING: Yes. So if you look at what an index-tracking fund is doing, it’s giving you broad exposure to a particular market, therefore has considerably lower turnover than an equivalent active fund. And for that reason, combined with you also not needing to make active fund management decisions, that’s the reason that these funds are frequently also referred to as 'passive fund' or 'passive investing'.

NIKI CHESWORTH: But how do they then track the index? Does that mean you have to go and buy every single share in a particular index in the right proportions? How does it actually work?

JULIAN HARDING: Well, if you look at the various methods there are for index-tracking, the simplest to understand and probably the purest form of index-tracking is full replication. And in that case you are holding every stock in exactly its index weights and introducing changes into the fund at precisely the same times as those changes are introduced into the index. What that means is that you produce a return very similar to that of the index, but what you’re needing to do is trade every single change no matter how small or insignificant, and so therefore there’s an element of cost that’s associated with that maintenance of the portfolio. It’s really the skill and expertise of the fund manager to efficiently implement those changes in a cost-effective way so that the tracking objective of the fund can be achieved.

NIKI CHESWORTH: So you still need some expertise as a fund manager, even though 'passive' sounds like they’re just sitting there drinking a cup of tea every day.

SIMON ELLIS: Most definitely. There is an art to passive investing. It’s not just using a computer program to track things as they move along. And obviously, to make sure it works well you need to have enough scale to include all the different constituents of some of the largest indices.

NIKI CHESWORTH: Oh well, yes, and scale obviously is important. Because if you wanted to do that yourself, you’d have to have a vast amount of money to buy every single share, for example, in the FTSE.

SIMON ELLIS: It’s critical.

NIKI CHESWORTH: And that’s why you buy it through a fund?

SIMON ELLIS: It’s absolutely critical.

NIKI CHESWORTH: So, Julian, we’ve mentioned that there are other ways, more sophisticated ways perhaps, to track an index. Can you explain what some of these are?

JULIAN HARDING: Yes, a couple of those would be stratified sampling or optimisation. If I take stratified sampling first, that’s where you break down an index into a number of subgroups, then you select a sample of stocks or bonds for each subgroup within that index. So that overall you’re mirroring the characteristics of the index but without necessarily holding every stock within the index at precisely its index weight.

NIKI CHESWORTH: And the second one – how does optimisation work?

JULIAN HARDING: Optimisation, that relies on computer models. By their very nature, they’re backward-looking, relying on historical information to create the model and hence the tools for constructing portfolios. They’re essentially used where you have either a small fund with limited cash-flows or you’re wishing to select a very limited number of constituents, stocks or bonds, to represent a much broader index.

By their nature, both of these methods aren’t replicating the index that closely, and so therefore there is the opportunity for a slight deviation in the returns of those funds compared to the underlying index.

NIKI CHESWORTH: That all sounds quite complicated! From an investor’s point of view, well, what does it matter?

JULIAN HARDING: From an investor’s point of view, it’s really down to understanding what you’re investing in. And so having a broad, diversified, near fully replicated portfolio will give you greater certainty in the returns that you’ll achieve from that fund.

NIKI CHESWORTH: So, as with everything in investing, it’s understanding what you’re buying that’s the most important thing?

SIMON ELLIS: Very much so, yes.

NIKI CHESWORTH: The other thing, of course, that investors always need to be aware about is the fact that the value of their investments can fall as well as rise. But I suppose it’s quite reassuring that part of their fund, you know, that their portfolio will be invested in an index-tracker and will at least hopefully replicate the movement in an index. And presumably that reassurance is quite comforting?

SIMON ELLIS: Yeah, I think a lot of investors want to know that if they’re choosing a market to invest in, they’re going to get the performance of that market. If they go with their active investment management, they’re hoping that their fund manager can do a good job, but they have no reassurance that that’s necessarily going to happen.

NIKI CHESWORTH: And of course, a lot of the tracker funds are UK-based – FTSE and All-Share. We all invest quite heavily anyway in the UK. Should that be an area that we should be worried about?

JULIAN HARDING: When you’re investing in the UK, you’re actually getting a lot more diversification than just exposure to the particular home market. If you look at the companies within the FTSE All-Share, a lot of those have overseas subsidiaries, significant overseas operations. And indeed, even those that have the bulk of their operations here are increasingly international in their trading, and that can even be on a global basis. So you’re getting broad international exposure even by investing in UK companies.

NIKI CHESWORTH: So if you’re investing in a UK tracker, at least you get some exposure to global markets. And we’ve also discussed that this is a lower-cost way of investing, and you’re also in a fund that aims to replicate the movements in a particular index. So that’s passive investing – a little bit more exciting than it sounds!

Please bear in mind, Index-tracking funds may not exactly match the performance of an index. The decisions made by fund managers on how and when to make changes to the fund along with the charges incurred in making these can result in the performance of the fund being different to that of the index it is tracking.

The value of investments and any income you may receive from them may fall as well as rise and you may not get back the money you invested. Although there is no fixed term, you should consider investments of this type as a medium to long-term commitment of, ideally, at least five years or longer.