| Index funds 101 |
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| 23/10/2005 | |
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Christine Franquin, index fund manager at Vanguard Investment Europe, answers this week's 101 on index funds. 1-What are the differences between an active management fund and an index fund? Active managers seek to outperform a market index while index fund managers seek to replicate the performance of an index. An index fund seeks to replicate the performance of the index by trying to match the risk characteristics of the index as closely as possible and at the lowest possible cost. The generation of alpha is not on the agenda of an index fund manager. In active management, the index is used as a point of comparison only. The ultimate objective of an active manager is to add alpha by making bets on securities away from the index. Those with strong convictions and seeking absolute returns would reach, for instance, tracking errors equal or above 10%. Others would typically keep lower tracking errors between 2% and 10%: these are often referred to as "closet indexers" because their performance is often highly correlated with the index, but the fund charges active management fees. In the US, at least 90% of the performance of 81% of large cap funds is due to the performance of the S&P 500 index, according to Morning Star and the Bogle Research Centre. Already large in the U.S., index funds are gaining more traction in Europe as their benefits are recognized by institutional and individual investors. Over the long term, statistical analysis shows that the average active manager underperforms the market. For instance, over 10 years, 90% of active European equity funds underperformed the MSCI Europe index*. Provided that the underlying index is broadly diversified, index funds also bring the benefits of diversification over the long term: only the MSCI Europe index contains about 600 European securities. Another difference is that index funds charge lower fees than active funds. Management fees of index funds are usually lower because of the passive manager's focus on optimising transaction and execution costs. Active funds often display higher turnover ratios (and therefore transaction costs) and have to charge for research. Turnovers of index funds are typically lower. 2-Does passive management mean that the manager is not doing anything once the initial investment has been made? A passive manager both has to replicate the index and minimise the cost of doing so since it is then subtracted from the fund's performance. To achieve this, the focus is put on transaction costs, which are reduced through the use of the most cost effective methods on the market such as DOT systems or Electronic Crossing Networks. Managers also seek to minimise the market impact of their transactions when adjusting a fund following an index re-weighting. Moreover, any serious passive manager should see "best execution" as a key success factor and avoid directed brokerage or soft commissions. 3-What about the opportunities for securities lending in an index fund? Securities lending is possible in an index fund since the securities are held for a long period of time - often over 10 years. However, securities lending operations have to be closely monitored and allowed by the fund's prospectus and the portfolio manager, who determines the assets, as well as their quantities, that can be lent. Lending should be done transparently and investors should understand how securities lending revenues are split between the different parties (the manager, the fund, the custodian, etc.). * Net of fees, including survivor bias. The index is net dividend reinvested. Source: The Vanguard Group. |
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Articles of the same Serie : 101 |
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Articles of the same Topic : Portfolio management |
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