PASSIVE FUNDS MAKING FAIRER COMPARISONS. Viewpoint IN THIS ISSUE. Analysing index fund performance requires taking a closer look at the benchmark

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1 This document is for investment professionals only and should not be relied upon by private investors PASSIVE FUNDS MAKING FAIRER COMPARISONS Analysing index fund performance requires taking a closer look at the benchmark Viewpoint IN THIS ISSUE 2 MORE CHOICE MAKES PASSIVE FUND ANALYSIS EVEN MORE IMPORTANT 3 THE IMPORTANCE OF COMPARING LIKE WITH LIKE 6 COMMONLY TRACKED INDICES AND HOW THEY DIFFER 8 DISTINGUISHING BETWEEN REAL AND APPARENT CAUSES OF TRACKING DIFFERENCE 10 ENSURING A FAIRER ASSESSMENT 11 INDEX OPTIONS AVAILABLE ON FUNDSNETWORK

2 This document is for investment professionals only and should not be relied upon by private investors Passive funds can differ in many ways and so taking a closer look can be crucial IN THIS ISSUE 2 THE GROWING MARKET FOR INDEX FUNDS 3 WHAT TO LOOK FOR IN AN INDEX MANAGER 11 INDEX FUNDS ARE NOT ALL THE SAME This document is for investment professionals only and should not be relied upon by private investors Using a core-satellite approach to blend active and passive funds together IN THIS ISSUE 2 BLENDING PASSIVE AND ACTIVE STRATEGIES TOGETHER CAN BRING MANY BENEFITS 3 DIVIDE AND CONQUER 4 INCORPORATING INDEX FUNDS INTO CLIENT PORTFOLIOS This document is for investment professionals only and should not be relied upon by private investors Examining different passive options for client portfolios IN THIS ISSUE 2 INCREASING CHOICE IS FUELLING THE GROWTH OF PASSIVE INVESTING 4 INDEX TRACKING A SIMPLE CONCEPT 5 INDEX FUNDS KEY CHARACTERISTICS 6 EXCHANGE TRADED PRODUCTS KEY CHARACTERISTICS 8 COMPARING CHARGES 9 INDEX FUNDS AND ETPs: AT-A-GLANCE SUMMARY 10 MAKING YOUR CHOICE 11 INDEX OPTIONS AVAILABLE ON FUNDSNETWORK MORE CHOICE MAKES PASSIVE FUND ANALYSIS EVEN MORE IMPORTANT As we have highlighted in other Viewpoints, passive investing is now very much a mainstream investment philosophy. The popularity of the approach is reflected in figures from Platforum1, who estimate that 88% of advisers are now using at least some passive funds in client portfolios. Indeed, their research suggests that 10% of advisers have embraced a mostly passive approach. The trend towards holding a greater proportion of passive investments is hardly surprising given the low costs associated with the strategy and the fact that investors can rely on returns close to those of the benchmark index. Greater demand is also resulting in increased choice with more passive options becoming available all the time. This is being reflected on the FundsNetwork platform, with over 200 passive fund options and Exchange Traded Products now available to investors. With a wider universe of passive options to select from, going through a rigorous due diligence process is, of course, vital when selecting a fund for a client. As with active funds, there are many factors to consider when selecting a passive investment for a portfolio. Price is usually one of the key considerations as is the methodology employed by the fund manager. Performance relative to other index tracking investments and tracking difference compared to the benchmark are also often taken into account by advisers. However, care needs to be taken when looking at performance/ tracking difference because many factors can distort the real picture. This Viewpoint therefore considers the areas to examine when analysing the performance/tracking difference of an index fund. It highlights the importance of understanding a fund s benchmark index and, in particular, the treatment of dividends. SELECTING THE RIGHT INDEX MANAGER Viewpoint INCORPORATING INDEX FUNDS INTO CLIENT PORTFOLIOS Viewpoint INDEX FUNDS AND EXCHANGE TRADED PRODUCTS COMPARED Viewpoint Read our complementary Viewpoints on passive investing Further insights on index tracking investments can be found within three other Viewpoints available on our website. Selecting the right index manager defines all the factors you should consider when selecting an index fund while Incorporating index funds into client portfolios looks at how index products can form part of an individual s investment strategy. Finally, Funds and Exchange Traded Products compared examines the two main ways of passive investing. You can access these at fundsnetwork.co.uk/index 1Platforum research, Q PASSIVE FUNDS MAKING FAIRER COMPARISONS

3 THE IMPORTANCE OF COMPARING LIKE WITH LIKE As with any performance comparison, it is vital to ensure that you are comparing like with like when evaluating index funds. Judging the performance of a passive investment may seem straightforward but it can be relatively easy to make the following errors: Comparing funds which, although they appear to track the same market or region, actually invest in a different range of stocks/markets Comparing a fund to the incorrect variant of a benchmark We now examine how these two mistakes can occur. 1. Understanding the benchmark funds often have very similar names and so it is easy to assume that they track the same market(s). For example, the Fidelity US Fund and Legal & General US Trust sound the same but they actually track different market indices. The Fidelity fund follows the S&P 500 (a large-cap only index) while the L&G fund tracks the FTSE USA (a large and mid-cap index). Comparing the performance of these two funds is therefore, to a large degree, inappropriate. However, establishing which benchmark an index fund is following should be relatively straightforward as it is usually specified within a fund s investment objective. Fund factsheets should also clearly show which index is being tracked. It is just as important to recognise that benchmark names are not always intuitive. There can be considerable differences, for example, between the two main regional index ranges (MSCI and FTSE) in terms of geographic and market cap coverage. The MSCI Pacific ex Japan, for instance, is comprised of just four of the five developed markets within the region (Japan is excluded). In contrast, the FTSE Asia Pacific ex Japan is comprised of both developed and emerging markets and so, PASSIVE FUNDS MAKING FAIRER COMPARISONS 3

4 THE IMPORTANCE OF COMPARING LIKE WITH LIKE in total, the benchmark encompasses 13 different countries. The FTSE World Asia Pacific ex Japan, however, consists of only 8 developing and advanced emerging countries, showing that the inclusion of "World" can have a significant impact on the structure of an index. Both index providers also differ over their definition of certain developed and emerging markets (FTSE regards Greece and South Korea as developed markets, for example, while MSCI considers them to be emerging markets). The table on pages 6-7 highlights the differences between some of the most popular indices tracked by funds available to UK investors. It illustrates why care needs to be taken when comparing two seemingly similar passive investments. 2. Measuring against the correct index variant The second issue to be aware of when comparing the performance of index tracking funds is that there can be many different variants of a benchmark. The treatment of dividends, for example, will affect the return delivered by a fund/index and therefore most major indices have three main variants so that performance can be judged more accurately: Price index capital only Gross Total Return (may be shown as G, GR or TR ) includes dividend reinvestment gross of withholding tax 4 PASSIVE FUNDS MAKING FAIRER COMPARISONS

5 Net Total Return (may be shown as N, NR or NTR ) includes dividend reinvestment net of withholding tax and usually does not take into account double taxation treaties. This lettering can help to ensure an appropriate and fair performance measurement is made. Even though different index variants are available to aid fair comparisons, challenges can still arise. Withholding taxes is one such issue. Funds can be subject to different withholding tax treatments depending on their domicile/ legal structure. For example, UK or Irish funds tend to incur 15% withholding tax on US equities while Luxembourg domiciled funds can incur a rate of 30%. The withholding tax rates can differ to the rates priced into Net Total Return indices. Over time, these differences can have a considerable effect on tracking difference. Other issues to be aware of include the fact that some data vendors may not always select the right index variant; some managers may not provide the necessary detail to enable the correct variant to be selected; some managers use indices which have been customised by the index provider and which may not be available to data vendors. Fidelity s approach to selecting index variants for performance measurement The policy to which Fidelity adheres to is to select the benchmark variant which aligns most closely to the fund s tax treatment. In most cases we use standard net total return indices. There are three exceptions: S&P 500 here we use a NUK (net of UK tax) index which S&P have customised for us. This is because the standard S&P 500 net total return index is net of 30% withholding tax whereas for our fund the withholding tax is reduced to 15% (as a result of the double taxation agreements between the UK and US). Therefore, neither the standard gross or net total return indices align to the fund s tax treatment. As a result, we asked S&P to customise an index for us in order to provide a fairer measurement of tracking difference. MSCI Europe ex UK here we use a gross total return index. This is because the fund s tax treatment aligns more closely to this than for the net index due to ongoing tax harmonisation across Europe under the European Court of Justice process. For example, French dividends are now effectively paid gross to EU domiciled funds whereas 30% withholding tax was previously applied. However, dividends from some countries are still not paid on a gross basis and so this results in a source of negative tracking difference for our fund. Because of the cycle on when European companies pay dividends, the tracking difference of our fund is expected to fluctuate (widen/lessen) at different times through the year. FTSE All Share here we use a FTSE custom Mid Day index so that it aligns to our fund s valuation point. This is also a gross total return index. With the majority of companies in the index being UK tax resident companies, their declared dividend is reflected in the index and this aligns with how they are received by the fund. There are a small number of non-uk tax resident companies in the index where dividends are liable to withholding taxes (though not necessarily at the same rates as those reflected in the net index). This is therefore a source of very small negative tracking difference within our fund. Please note we use a net total return index for the Fidelity World Fund, which results in a positive source of tracking difference for this fund. This is because the fund s withholding tax leakage has reduced due to the ongoing tax harmonisation process across Europe. customisation is not a straightforward option in this case, given the index includes 23 countries. PASSIVE FUNDS MAKING FAIRER COMPARISONS 5

6 COMMONLY TRACKED INDICES AND HOW THEY DIFFER REGION BENCHMARK BENCHMARK DESCRIPTION NO. OF CONSTITUENTS FUND EXAMPLES UK Europe ex UK FTSE All Share FTSE 100 MSCI Europe ex UK FTSE (World) Europe ex UK FTSE Developed Europe ex UK North America S&P 500 Japan S&P US Total Market FTSE North America FTSE USA MSCI Japan FTSE Japan An all-cap index representing 98-99% of UK market capitalisation. A large-cap index measuring the performance of the UK s largest 100 companies by capitalisation. comprising 14 developed markets in Europe (this index does not include Greece). An all-cap index which includes exposure to both developed and emerging markets in Europe (and so includes markets such as the Czech Rep., Greece, Hungary, Poland, Russia and Turkey). An all-cap index comprising 15 developed markets in Europe (this index includes Greece). A large-cap index covering approximately 80% of available market capitalisation within the USA. An all-cap index offering broad exposure to large, mid, small and micro-cap companies within the USA. comprising companies within both the USA and Canada. comprising companies within the US only. 646 Fidelity UK Fund Aviva Investors UK Tracking Fund BlackRock UK Equity Tracker Fund F&C FTSE All Share Tracker Fund HSBC FTSE All Share Fund Legal & General UK Trust Vanguard FTSE UK Equity Fund 101 BlackRock 100 UK Equity Tracker Fund HSBC FTSE 100 Fund Legal & General UK 100 Trust 329 Fidelity Europe ex UK Fund 478 BlackRock Continental Europe Equity Tracker Fund Legal & General European Trust 392 HSBC European Fund Vanguard FTSE Developed Europe ex UK Equity Fund 502 Fidelity US Fund HSBC American Fund 3909 Vanguard US Equity Fund 726 BlackRock North American Equity Tracker Fund 650 BlackRock US Equity Tracker Fund Legal & General US Trust. 312 Fidelity Japan Fund Vanguard Japan Stock Fund. 474 BlackRock Japan Equity Tracker Fund HSBC Japan Fund Legal & General Japan Trust Royal London Japan Tracker Fund 6 PASSIVE FUNDS MAKING FAIRER COMPARISONS

7 Pacific ex Japan Emerging Markets World MSCI Pacific ex Japan FTSE World Asia Pacific ex Japan MSCI Emerging Markets FTSE Emerging Markets MSCI World FTSE World ex UK FTSE Developed ex UK comprising four of the five developed markets in the region (Australia, Hong Kong, Singapore and New Zealand but not Japan). covering developed and advanced emerging markets in Asia, excluding Japan. This index includes Korea, Taiwan, Malaysia and Thailand in addition to Australia, Hong Kong, Singapore and New Zealand. comprising 23 emerging market countries: Brazil, Chile, China, Colombia, Czech Rep., Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and UAE. comprising 22 emerging market countries: Brazil, Chile, China, Colombia, Czech Rep., Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and UAE. covering 23 developed markets including the UK. covering 34 developed and advanced emerging markets excluding the UK. covering 24 developed markets excluding the UK 143 Fidelity Pacific ex Japan Fund Vanguard Pacific ex Japan Stock Fund 528 BlackRock Pacific ex Japan Equity Tracker Fund HSBC Pacific Fund Legal & General Pacific Trust Royal London Asia Pacific ex Japan Tracker Fund 834 Fidelity Emerging Markets Fund Vanguard Emerging Markets Stock Fund 901 BlackRock Emerging Markets Equity Tracker Fund Legal & General Global Emerging Markets Fund 1615 Fidelity World Fund 2533 Aviva Investors International Tracking Fund Legal & General International Trust 1977 Vanguard FTSE Developed World ex UK Equity Fund Source: Fidelity, Providers, September PASSIVE FUNDS MAKING FAIRER COMPARISONS 7

8 DISTINGUISHING BETWEEN REAL AND APPARENT CAUSES OF TRACKING DIFFERENCE The divergence of performance between a fund and the index is known as the tracking difference. When analysing and comparing the performance of a fund, it is important to recognise that there are real and apparent causes of tracking difference. Real causes of tracking difference Real causes of tracking difference can be a good way of comparing the merits of individual index funds. They include: The accrual of the fund s ongoing charge The tracking method employed by the manager Transactions costs related to the buying and selling of the underlying securities How efficiently cash flows are managed within a fund. You can find out more about how these factors influence the performance of an index fund by reading our Viewpoint entitled Selecting the right index manager, which is downloadable on our website. Apparent causes of tracking difference Apparent causes of tracking difference appear in quantitative screens of index funds but do not reflect actual investment decisions or ability. Failing to account for these factors can therefore lead to unfair performance comparisons: The timing of valuation points This factor can have a pronounced impact and occurs when a fund is priced at a different time to the index being tracked. Some funds, for instance, are valued at midday while the index is valued at the end of the trading day. Given markets can move significantly over the course of a few hours, this can potentially lead to distorted performance comparisons. An example of this issue is shown by the chart opposite, which shows the tracking difference for the Fidelity UK Fund. The grey line indicates the tracking difference based on the fund s midday valuation point and index valuation point of 4.30pm. As you can see, the line is quite volatile giving the impression that the tracking difference of the fund fluctuates quite wildly. A truer comparison can be made by recalculating performance against a customised index which is aligned with the fund s valuation point. The blue line shows the same metrics if valuations are both taken at midday. This illustrates that the tracking difference of the fund has actually kept closely in line with the benchmark. This is why Fidelity use the FTSE All Share Mid Day as the benchmark for the Fidelity UK Fund. It is also important to take account of any differing valuation points if you are comparing one index fund to another. 8 PASSIVE FUNDS MAKING FAIRER COMPARISONS

9 Tracking difference using different valuation points Tracking difference vs. index 102 Fidelity UK Fund compared to the FTSE ALL Share TR (end of day) Fidelity UK Fund compared to the FTSE ALL Share Mid Day TR Mar 14 Apr 14 May 14 Jun 14 Jul 14 Aug 14 Sep 14 Source: FIL Limited, Class P accumulating, since launch (3 March 2014) to 30 September 2014, bid-bid, net income reinvested, in GBP. Fair valuation Some overseas markets may be closed when a fund is priced. Many things can happen while the market is closed and these events can impact on stock prices when it reopens. In such circumstances, a fair valuation adjustment may be applied by the manager which reflects the shift in share prices. This move helps to protect existing investors in the fund. Price adjustment policy A fund s price can be adjusted when there are significant inflows or outflows on any given day. The adjustment is based on an estimate of the dealing costs and ensures that trading costs are borne by the investor(s) behind the large flow rather than by all the investors in the fund. Performance NAV Many fund providers produce a performance NAV (PNAV) to help remove the effect of some of these apparent causes of tracking difference. This shows how the fund would have performed if the pricing points had been aligned with the index and removes the impact of any fair value or pricing adjustments. PASSIVE FUNDS MAKING FAIRER COMPARISONS 9

10 ENSURING A FAIRER ASSESSMENT As we have highlighted, judging the performance of an index fund against another index fund or comparing its tracking difference to the benchmark is far from straightforward. Fairer comparisons can be made if you take steps to ensure you are comparing like with like. These include: Making sure that the funds you are comparing track the same index Selecting the correct index variant when comparing a fund to a benchmark While the majority of index funds have no upfront charges, some do, so it is important when comparing their performance to include up front charges and not to just compare on a bid to bid basis You can find out which benchmark a fund is tracking, the appropriate index variant and whether any initial charges apply by viewing the provider fund factsheets available through FundsNetwork. Of course, even when you are sure you are comparing like with like, you still need to recognise that other factors can skew the accuracy of a comparison. In particular, you should be aware of any apparent causes of tracking difference, such as differing valuation points, which may give a false picture of how accurately a fund is tracking its benchmark. Helpfully, most provider fund factsheets list a fund s valuation point while many data providers will also capture this information for a fund. 10 PASSIVE FUNDS MAKING FAIRER COMPARISONS

11 INDEX OPTIONS AVAILABLE ON FUNDSNETWORK FundsNetwork offers a broad range of index tracking investments to meet a wide range of client needs. In total, there are currently over 200 passive options available, a number which is growing all the time. The FundsNetwork Fund Evaluator tool can help you search out the right solution for your clients' needs. Simply visit our website, launch the tool and then tick the 'Passive Funds' box in the left hand column to filter the list. If you wish to filter by region or investment sector, you will need to log into Client Management first. Visit our index support zone at fundsnetwork.co.uk/index for more on investing in index funds including other Viewpoints giving further perspectives on passive investing. THE FUNDSNETWORK FUND EVALUATOR TOOL CAN HELP YOU SEARCH OUT THE RIGHT SOLUTION FOR YOUR CLIENTS' NEEDS. Introducing the new Fidelity equity fund range The Fidelity equity fund range offers your clients access to a broad range of markets from just 0.07% (ongoing charges), exclusively through FundsNetwork. This makes them the market leading, low-cost passive fund range currently available through a fund platform today. Seven different fund options: UK Europe ex UK US Japan Pacific ex. Japan World Emerging Markets Great value fixed ongoing charges for example, just 0.07% and 0.08% for the UK and US index funds respectively Accumulation and income shares are available across the range Fully integrated into the platform they are available within FundsNetwork s ISA, Pension and International Bond as well as non-tax wrapped accounts and can be included within your model portfolios. Importantly, Fidelity has priced the range to be highly transparent. The fixed ongoing charging structure means costs are consistently low. A FundsNetwork platform service fee of 0.25% does apply as will our annual investor fee of 45. For more information, simply visit fundsnetwork.co.uk/index or call today. PASSIVE FUNDS MAKING FAIRER COMPARISONS 11

12 For more on our extensive range of passive solutions, visit: fundsnetwork.co.uk/index or call The FTSE All-Share is calculated by FTSE International Limited. FTSE International Limited does not sponsor, endorse or promote this product. All copyright in the index values and constituent list vests in FTSE International Limited. Fidelity has obtained full licence from FTSE International Limited to use such copyright in the creation of this product "FTSE "and "Footsie " are trade marks jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE International Limited under licence. "All-Share " is a trade mark of FTSE International Limited." S&P and S&P 500 are registered trademarks of Standard & Poor s Financial Services LLC ( S&P ) and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC ( Dow Jones ). These trademarks have been licensed for use by S&P Dow Jones Indices LLC ( SPDJI ) and, in some cases, sublicensed to FIL Investment Management Limited ("FIL"). The S&P 500 NUK (the ) is a product of SPDJI and/or affiliates and has been licensed for use by FIL. The Fund is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates or their third party licensors (collectively SPDJI Entities) and SPDJI Entities make no representation regarding the advisability of investing in such product. Some Fidelity funds described herein are indexed to an MSCI index. The funds or securities referred to herein are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such funds or securities or any index on which the funds or securities are based. The Fund Prospectus contains a more detailed description of the limited relationship MSCI has with Fidelity and any related funds. This document is for investment professionals only and should not be relied upon by private investors. The value of investments can go down as well as up and clients may get back less than they invest. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity Worldwide Investment, FundsNetwork, their logos and F symbol are trademarks of FIL Limited. CSO6808/na