Passive Fund Management

Question 1

Describe passive fund management

Answer 1

• Aims to match a portfolio with the performance of an index
• No investment management decisions
• Based on belief it is impossible to beat the market

Question 2

Advantages and disadvantages of index tracking funds

Answer 2

Advantages:
- Simple
- Easy to understand
- Returns in line with index
- Lower costs

Disadvantages:
- Tracking error
- Follow markets which go down as well as up

Question 3

Passive fund management methods

Answer 3

Physical replication

Synthetic replication

Question 4

Describe 3 methods of physical replication

Answer 4

• Full replication - most expensive
• Stratified sampling is a representative sample - less expensive
• Optimisation - uses computer modelling technique to find a sample of securities

Question 5

Describe synthetic replication

Answer 5

• This type of ETF uses swaps and other derivatives to achieve accurate replication of an asset, as opposed to a physical ETF which is constructed using the asset itself
• Exchange returns on index for payment
• Unfunded or funded swap
• Lower cost method
• But investor is exposed to counterparty risk

Question 6

Tracking error formula

Answer 6

Portfolio return - benchmark return

Low tracking error means a portfolio is closely following the benchmark and vice versa

Question 7

Why might a tracking error occur?

Answer 7

• Optimisation can mean tracking error as portfolio has fewer stocks than in index
• Timing of dividends can create a drag on performance
• Some indices are more difficult to track

Question 8

Considerations when evaluating index funds

Answer 8

• Underlying index
• Structure e.g. physical or synthetic replication / level of tracking error
• Tax - domicile of fund
• Costs - management charges / trading costs
• Dealing - liquidity