Want Transparency When Investing? Opt for Passive Funds

By virtue of simply tracking an index, passive fund managers are not under pressure to keep information on fund holdings away from public eyes. There is nothing to hide

Jose Garcia Zarate 27 July, 2015 | 10:50AM
Facebook Twitter LinkedIn

Investing is all about taking risks on the expectation of a return.  By nature it is an activity fraught with uncertainty and investors have little option but to accept the unpredictability of returns. We are constantly reminded that past performance is not a guide for the future, however investors can take steps to minimise the ignorance of the risks assumed.

The growing popularity of passive investing over the last decade has been partly predicated on the high level of transparency associated with the management of passive funds compared to the active side of the industry.

Passive funds, particularly so exchange traded funds (ETFs), have been the subject of close scrutiny by regulatory bodies, international research bodies and media commentators. The passive industry’s response to this scrutiny has been one of maximising transparency in all aspects relating to the management of the funds, including comprehensive, regularly updated and, more important, easily accessible information of fund components and ancillary operations such as securities lending.

It goes without saying that by virtue of simply tracking an index, passive fund managers are not under pressure to keep information on fund holdings away from public eyes. There is nothing to hide. The benefit for investors is one of having full information to help them make an investment decision.  

The same cannot commonly be said for active managers, who routinely justify non-disclosure on the basis of protecting their investment ideas from competitors. While accepting the validity of this argument, the reality for investors in actively-managed funds is that in many instances they are left in the dark as to what fund managers do with their money. Ultimately, this may make them unable to properly assess whether the fees payed out are justified.  

Finding out that an active fund manager lost you money because of an ill-fated bet on Greece only when you get your annual statement is not particularly helpful. However, the need for increased transparency is not only justified for the eventuality of extreme market events. Indeed, take the issue of index-hugging by active fund managers. Of course, there are instances when it makes sense for active managers to just track the market if they feel it is in the interest of fund holders.

The problem arises when market-tracking within active funds becomes the norm rather than the exception. In that situation investors might as well save plenty in management fees – and thus enhance potential returns – by simply buying the low-cost passive alternative. But to do that, investors first need to have the means of finding out whether their active manager is a closeted indexer.       

The issue of the index-hugging in the active fund industry is one which regulatory bodies across Europe are slowly waking up to. And rightly so; as it is one of the main problems investors face owing to lack of transparency. Demanding active managers to fully disclose their investment actions on a real time basis is not a realistic proposition.

However, demanding them to routinely disclose its present and historical active share – the percentage of the fund’s portfolio that differs from the benchmark – is. Active share should not be taken as the only indicator to make a firm judgment on whether to invest in an active fund. However, making the information available would help investors decide whether paying a high management fee is justified.

This article originally appeared in Investment Adviser magazine

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

About Author

Jose Garcia Zarate

Jose Garcia Zarate  is Associate Director of Passive Strategies Research for Morningstar Europe