In our article “How to evaluate the performance of an investment fund?” we have seen that this performance is usually compared to an index which reflects the overall development of the market in which the fund invests. This index is the fund’s “benchmark”.
If the index increases for example by 5% over a certain period and the value of the fund assets increased by only 2% over the same period, the fund has achieved an “underperformance” in comparison to the overall market. However, if the value of the fund’s assets rises by 7% over this period, the fund has achieved an “outperformance”, it has managed to “beat the market”.
Beating the market is, of course, the goal of every ambitious fund manager, not only on sporting grounds. Although a good performance in the past is no guarantee that a Fund will continue to generate profits in the future, the performance remains the main criteria for many investors when choosing an investment fund. A good performance is thus a fund’s best marketing argument.
In our post about how funds invest, we have already seen that it is very difficult for a manager to consistently be invested in shares whose prices rise more strongly than the market average, but this is a prerequisite for beating the market. At worst, he is predominantly invested in shares whose prices rise less than the market average or even fall. The result is a performance that is significantly lower than the stock market index that the fund compares with – a nightmare for any manager.
To avoid this risk, some managers have opted for a relatively simple solution: They replicate their benchmark.
No research needed: Your benchmark tells you what to buy
Take the example of the German Dax, the benchmark index of the Frankfurt Stock Exchange. To calculate this index, the Frankfurt Stock Exchange takes into account the stock prices of the 30 largest German companies whose shares are most traded at the Exchange.
The weighting of each of these companies in the composition of the index depends on the daily trading volume and the number of shares in circulation. Thus, the weight of the insurance company Allianz is 7.97% for example, that of the automobile manufacturer Daimler 8.11% and of the semiconductor producer Infineon Technologies 1.68% *.
To replicate the DAX index, the manager is going to invest 7.97% of the collected funds in Allianz shares, 8.11% in Daimler shares, 1.68% in shares of Infineon Technologies and so on, until he has all 30 stocks that make up the index in his portfolio.
If the DAX index climbs, which means that the prices of the shares that compose the index are rising, the manager can be sure that the value of the fund’s portfolio will grow in the same proportion. (The fund’s performance will always be slightly lower than that of the index due to costs related to the purchase and custody of securities and administrative costs of the fund.)
What does this mean in practice?
For the fund manager: a more peaceful life. Since the composition of a stock index is publicly known, it is sufficient to stick to it carefully when investing to achieve a performance close to that of the index. At the same time he can do without any sophisticated and above all expensive research and analysis. On the other hand, the fund’s performance will never be better than the market index.
For investors: significantly lower costs. As a passively managed fund has no research to finance, its operating costs – which are always charged to the investor via different types of commissions – are very low compared to actively managed funds. Thus, subscription fees charged to investors for the purchase of passive funds often represent only a fraction of those charged by active funds.
Regarding the fund’s performance, we have seen that if follows that of the replicated index. If the index rises, the fund’s value also rises, but never more than the index. However, if the index is falling – a sign of a declining market – the value of the fund also decreases, and it will decrease just as sharply as the index.
Thus a passively managed fund does not provide the opportunity to achieve a performance that is better than the market index, but it does not bear the risk that its performance will be significantly poorer than the index either.
Passive funds are often traded at the stock exchange – these are the famous Exchange Traded Funds or ETFs – so that investors can buy or sale these funds at any time.
* as at 27 May 2016