A goal of passive investing is to match the market return as closely as possible.
However, it is not a given that a passively structured investment will match its own market. In fact, there may be material variations between different investments and the benchmark index performance.
Index funds (both mutual and exchange traded) are typical passive investments. Here is why they do not normally exactly match their benchmark returns.
Operating Costs
Index funds incur operating costs that are not present in the benchmark index.
While there may be little to no management fees charged, there will still be expenses for: commissions on buying and selling securities; accounting for fund assets; shareholder communications; regulatory filings; staff salaries; etc.
These costs cannot be avoided. Any fund that you invest in will be at an immediate disadvantage in trying to match the market return.
The more efficient the fund, the lower the relative costs. As well, there is often economies of scale for larger funds. Operating costs cannot be avoided entirely. But be sure to compare funds before investing. There will be differences.
Transaction Timing
Even if we could avoid all fund costs, it still may still be difficult to exactly match the benchmark index performance.
Securities need to be bought and sold on the open market to properly track an index.
For example, per a June 19, 2018 S&P Dow Jones Indices news release, “Walgreens Boots Alliance Inc. (NASD:WBA) will replace General Electric Co. (NYSE:GE) in the Dow Jones Industrial Average (DJIA) effective prior to the open of trading on Tuesday, June 26.”
If you are an index fund that mirrors the Dow 30, you may need to sell your holdings of General Electric and replace them with Walgreens. There is no guarantee that the price you receive for General Electric, or pay for Walgreens, will be the same as calculated by the benchmark as at the close of business on June 25. This likely will create a variance in fund performance versus the benchmark.
Compounding this problem is that there are many funds that track this index.
The more funds that reflect a specific index means more competition for shares of securities added to an index and more sellers of securities that have been removed from an index. If there is suddenly either increased supply or demand, it can cause significant price fluctuations.
When a fund can invest and divest securities may have an impact on its performance versus the benchmark. Think of the price impact on General Electric as all the tracker funds holding this stock sell their shares. And what will be the short-term price impact on Walgreens as these same funds buy all available shares of this stock?
Obviously, the smaller and/or less liquid an index, the greater the fluctuations likely between purchase and sale prices on equities entering or leaving the index.
Fund Construction
Variances between performance in the benchmark and index funds may relate to how the fund is structured.
Not all index funds are created equally.
Index funds may be created using full, partial, or synthetic replication.
Full Replication
Full replication involves holding every security in the index in its appropriate weighting.
With complete replication, an index fund’s gross returns should be close to to the index itself.
As the relative weightings of securities can fluctuate based on security price and capitalization, to stay fully replicated may require frequent trading. How quickly the fund can adjust its portfolio will impact matching gross index returns.
Also, increased trading will increase fund operating costs. This reduces fund performance versus the actual index which does not incur any expenses. The increased fund turnover can also create taxable capital gains for investors, once again impairing net returns.
Partial Replication
Partial replication does not hold all an index’s securities. Instead, it only maintains a representative sample of the securities within the index.
The better the sampling techniques, the closer the gross returns should be to the index. But when not fully replicating an index, there is a greater risk that actual returns will deviate from the actual benchmark or a portfolio using full replication.
This is known as the index fund’s tracking error.
Tracking error is not a one way street. It can also result in a fund achieving higher gross returns than the benchmark.
An advantage of partial replication is that by owning fewer securities, there is less trading (and transaction costs, administration expenses, triggering of capital gains, etc.) than under full replication.
Whether partial replication is preferable to full depends on the quality of the sampling technique.
Synthetic Replication
Whereas full or partial replication requires the fund to own all or some of the benchmark index holdings, synthetic replication does not.
Synthetic replication uses financial instruments to replicate the index performance. These may include the use of futures, swaps, and other derivatives.
An advantage of synthetic replication is that it is usually easier and more cost-effective to re-create and manage the benchmark using financial instruments rather than investing in individual securities.
There still may be some tracking error in performance depending on the specific benchmark index and the availability of financial instruments. For established markets though, tracking error should be small.
A potential problem arises for less established markets where finding an exact match of financial instruments is not simple. In these instances, the fund may need to rely on a less than perfect fit in trying to replicate the market. This will increase tracking errors.
Also, it may require the fund to enter into swaps with other entities to replicate the benchmark index. This creates counterparty risk (risk that one side of the transaction will not fulfill its obligations) and can impact fund performance should the counterparty default.
While trading and administrative costs are reduced with no actual securities being owned, there are still costs associated with a synthetic strategy. These include fees associated with the financial instruments used. In established markets, there are many options for replication, so the costs tend to be reasonable. But in less established markets, it may not be as easy to find replication solutions and the costs will rise.
It is not imperative that you memorize the mechanics of fund construction. It is simply a reality of index funds.
But always keep in mind that a passive investment may not exactly match the return of the market it represents. And the reasons for that lie (mainly) in the above points.
