The adviser s guide to Passive investing

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1 The adviser s guide to Passive investing Passive investing A fund-based strategy to replicate the performance of a basket of shares or an index in a low cost and transparent manner. In association with

2 For professional advisers only Foreword The future is not as black and white as active and passive. The simplicity and clean structure of index funds make them perfectly suited for the post RDR world of more transparent charging to investors and a simpler remuneration basis for advisers. Passive investing and index funds have been on the menu for advisers and their clients since the 1960s but over the last four decades they have always attracted polarised opinions. The appeal of passive strategies is clear: they are cheap and transparent, and the risks associated can be measured by the risk or volatility of the index the strategy is following, thus taking out the individual risk of the fund manager running an active portfolio. However, historically advisers have felt this is too simple a proposition to put before clients used to an active way of managing their portfolios and an accompanying charging structure. The correction in the markets made many advisers re-evaluate risk, particularly for clients invested in actively-managed funds and illiquid asset classes such as property, hedge funds or private equity. This brought them back to index funds and ETFs which offer constant liquidity combined with low dealing costs. The arguments have moved on further as the RDR landscape unfolds with the development towards advice being charged on a fee rather than commission basis and a greater transparency of charging structures. The simplicity and clean structure of index funds make them potentially well suited for the post RDR world of more transparent charging to investors and a simpler remuneration basis for advisers. But crucially the decision to put clients into passive funds does not need to be an either or in relation to actively managed funds. It is clear from the fallout from Lehman Brothers that diversification not just of asset classes, but of strategies, indices, management groups, counter parties and currencies will be integral to modern portfolio management. And this is why passive funds have an integral part to play in many clients portfolios. Depending on the client they can act as a complement to a portfolio traditionally based solely on active funds and for modern portfolio construction they are an essential tool which must be considered at the very outset when considering what is right and appropriate. Charging fees for advising on passive funds can be justified quite simply because they are as much a part of the portfolio as active funds and require the same level of due diligence. We hope this guide to passive funds and passive investing will help with your understanding of the sector and crucially provide you with some information on how to explain them clearly to your clients. Lawrence Gosling Editorial director, Investment Week and Professional Adviser

3 Andy Clark is on your side HSBC Global Asset Management s managing director offers some practical solutions to financial advisers grappling with the RDR amid an uncertain global economic outlook I feel real sympathy for the network of financial advisers in the UK. Undergoing the Retail Distribution Review during ordinary market conditions would present more than enough of an ordeal. Factor in the challenges that the unsteady global economic recovery continues to deliver and it s clear that for the medium term, advisers and their clients have quite a mountain to climb. Now that the discussion period of the proposed RDR legislation is closing though, clarity is improving on its ultimate impact. Some advisers will have to transform entire business models from commission to fee-based programmes in order to secure an income from their operations, balancing these pressures with the need to make sure that they achieve the foundation qualification level in order to simply trade as a financial advice business. The turmoil they are enduring is already a rallying call for product providers to assist as much as possible. Ongoing investigations at HSBC Global Asset Management into the potential impact of RDR continue to inform our decisions on how we should present our range of investment vehicles for the advantage of advisers and their clients at this time. An upside for advisers at the moment is that equity markets have stabilised somewhat and seem to be heading on a positive path corresponding with the recovery in corporate earnings and economic growth. The unanticipated consequence for product providers is that we have seen an increased appetite for index tracking vehicles. As indexation products had until now featured far less heavily in investors portfolio s in comparison with actively managed products, we think that this reflects advisers changing attitudes to indexation products and is possibly based on two key factors. Firstly, with fee-based structures now most certainly the future, advisers will cease to be able to draw a commission from the higher total charging structures inherent with most active managers and the pressure upon the Total Expense Ratios of portfolios is likely to grow. Thus we believe the recent uptick in demand for index trackers may build further from this footing. Recent independent research has also added further credence to the use of index tracking vehicles, and this may be contributing to the upward shift in sales. Using Morningstar data, we compared the mean annualised return from active managers of UK equities with the return from the FTSE All Share Index. We found that over a 1, 3, 5 and 10 year period the annualised growth rate of the index exceeded that of the average active manager. The same conclusion can be reached when comparing the average performance of an active US manager versus the index. Obviously the data does not take full account of cost implications, but, armed with this additional research we believe the outlook for all passive investment vehicles, not only those operated in developed markets, looks healthy. We predict sales will grow as advisers asset allocate to them in greater quantities in order to create lower-cost core positions in portfolios, or cheaply add a satellite allocation. And we re ready to help them. Our commitment to a passive investment vehicle range started in 1989 and has grown steadily since then. Our FTSE 100, 250 and All Share Index products maintain a full breadth of UK equity coverage while we also provide cost-effective vehicles to access the US, European, Japanese and more exotic Pacific Rim equity markets. Throughout this coming change we will continue to be a strong partner for advisers wishing to expand their knowledge of passive investment vehicles. Our entire range of index tracking products offer keenly priced annual management charges of 0.25%, are all rated AAA by Standard & Poors, (a first in the investment market) and feature conveniently on all the major platforms. We know that to be the choice of the IFA means providing and maintaining exceptional support. I believe our record within this sector speaks highly of our commitment, and that commitment will only continue to grow.

4 A Passion for Passive Harvey Sidhu, head of indexed equity at HSBC Global Asset Management, answers your queries about the world of passive investing What is a passive investment? The generally used definition of a passive management strategy is one in which a fund manager makes as few portfolio trading actions as possible. The key goal behind passive portfolio management, using the most common definition, is to minimise trading costs and other charges, such as capital gains tax. This objective is most stringently applied in the case of index tracker, which is an investment fund whose objective is to closely match the performance of an index, which may reflect the financial market of a given country, region or even industry sector. As an aside, although the passive concept is most commonly applied when discussing equity index tracking funds, it is, however, not exclusive to it. Indeed actively managed funds, where the fund manager makes specific investment actions with the goal of outperforming an investment benchmark index, can also be passively managed. For example, one could assert that when a long-term value investor buys and holds a favoured portfolio of stocks, he is managing more passively. What is an index or tracker fund? Unlike most actively managed funds, index tracking funds are predominantly exposed to the risks of the specific benchmark index that a fund is seeking to replicate, which should remove most of the risk of the fund underperforming that market index. An index fund does not seek to outperform its benchmark index and hence eliminates the requirement for the calculated bets of individual fund managers. From my experience, it seems somewhat unjust to describe an index tracking fund as being passively managed. For me, managing index funds is anything but passive! Although the investment objective is straightforward, in reality, the composition of a benchmark index is continually impacted by a multitude of factors, such as dividends, rights issues, mergers and acquisitions as well as regular index reviews. These corporate events must be carefully monitored and implemented while keeping a watchful eye on the costs associated with making these changes. How does a tracker fund work? There are several methods that managers can use to track an index. The most common and accurate approach is called full replication, where the tracker fund holds all of the benchmark constituents in the exact proportions as the index. This approach is particularly suitable for benchmarks with comparatively few but highly liquid members, such as the UK benchmark FTSE 100 Index or EuroStoxx 50 indices of the eurozone. However, there are many instances where full replication is an impractical and costly strategy to adopt. For example, some indices hold a large number of constituent members and, similarly, some contain stocks which can be difficult to access or trade. Examples would be the MSCI World or certain Emerging Markets indices. In many instances, these types of benchmarks are better replicated using mathematical models which construct a statistical sample of stocks intended to replicate the key risk characteristics of the index, rather than its exact composition. These sampling approaches can provide a pragmatic and cost-effective outcome. However, they typically are not able to track as closely and can be prone to error, especially when the market enters a crisis period, as recently observed. How do you construct a tracker fund? For us, the preferred method is full replication (holding each of the benchmark constituents in the exact proportions as the index). Where this is not practical, however, we apply a pragmatic full replication methodology, which blends full replication with a small degree of sampling. This latter strategy is applied for the product we manage which tracks the FTSE All Share Index where we identify a core component of the benchmark, characterised by the most concentrated, liquid and cheapest to trade stocks. In the case of the FTSE All Share index (currently consisting of 628 members) this core is identified as the FTSE 350 ex-investment trusts component, which represents 96% of the market capitalisation of the All Share, but with less than half of constituent names. The remaining 4% of the index market capitalisation is represented by FTSE Small Cap stocks and Investments Trusts,

5 which can be highly illiquid and costly to trade. This remaining component is then replicated by targeting a sample of the most significant and liquid stocks, while ensuring any sector risk exposure is eliminated. In our experience, this practical approach allows the fund to control trading costs and ensures the fund performs within its low tracking error target range. How do you keep track of changes in the Index? This keeps us very busy indeed, hence my earlier passives are not passive comment! In terms of changes to index constituents, HSBC has access to all major index providers data. We continuously monitor this data to keep track of all global index change notifications and the dates they are due to happen. The impact of these changes is analysed to determine significance and impact. We then decide on whether to trade and the appropriate approach to implement an index change. All significant index changes are traded with emphasis on minimising tracking error, trading costs and maximising transaction quality. This may involve early or late participation to minimise the costs associated with crowding when all funds rebalance at the same time increasingly observed with important index changes. We also carefully analyse the impact of participation of index changes by active investors, such as hedge funds, to determine the extent to which the price impact of an index change is already reflected in a security s price, increasing the possibility of trading our requirements at a favourable price. How do you assess risk in a passive fund? We know that the correct assessment of risk is close to the heart of many investors. Risk management is central to our investment process and we have a dedicated team of risk management specialists to ensure that portfolios are managed in accordance with client guidelines. Strong emphasis is placed on minimising investment and operational risks; our investment management process incorporates constant monitoring of portfolio positions, as well as strict observation of operational and counterparty risk factors. Risk management at HSBC Global Asset Management is fully integrated with the indexation process to ensure transparency and make certain the effectiveness of decision taking amongst the key investment professionals. The investment teams analyse sources of tracking risk by analysing the portfolios exposure on a bottom-up and top-down basis. Separately, the compliance department monitors portfolios on a daily basis to ensure that the portfolios are consistent with the clients guidelines and regulatory guidelines. What are the advantages of passive indexation investment? The most obvious advantage is the simplicity of the strategy. In an era where complex investment structures have been perceived to be central to the current problems in the global financial system, the straightforward approach of an index fund is an important appeal to investors seeking to better understand how their investment portfolios are being managed. Given the relative simplicity of the strategy, index funds can operate on a more cost effective basis as there is no need to hire a large team of analysts and fund managers. The strategy is also less prone to the risk of losing star fund managers. This type of investment provides transparency in that investors know what is held in the fund. As part of the risk-averse approach taken by HSBC in the management of its index funds, we avoid taking positions in complex overthe-counter derivatives used by some index fund providers. The strategy also offers a high level of diversification, giving investors the opportunity to invest in a wide range of stocks and business sectors in the relevant market. The recent turmoil in financial markets has affected the way many investors view risk. In volatile market conditions, a passive indexing equity approach, such as that offered by HSBC, can provide a controlled approach to minimising risk and transaction costs, while aiming to consistently achieve the returns available from a specific market. How do the costs compare with active funds? What about trading costs? Index tracker managers, like me, aim to consistently deliver returns as close as possible to those of the relevant market index. Minimising trading costs and other charges is central to achieving this objective for investors. Given the passive risks implied with the strategy, index funds tend to only transact on the basis of changes to the composition of a fund s benchmark and fund flows. In comparison, an actively managed fund will trade on the basis of changes in a fund manager s perception of the relative attractiveness of the stocks within its universe. Given that markets and corporate events are highly dynamic; these perceptions of attractive opportunities can alter very regularly, with its associated impact of trading within an actively managed fund. Clearly, index funds are not immune to the need to trade as the composition of an index will change over time. At HSBC, we employ a rigorous, quantitative approach to help determine the relative costs, benefits and risks associated with index changes. This analysis forms a key input to our trading decisions. What place can passive funds play in building a portfolio? Tracker funds can help investors to diversify their portfolios and offer the possibility of long-term positive returns on a cost-effective basis. Tracker funds can be particularly useful in developed and sophisticated stock markets, where a very large proportion of the financial information that investors require is available to all. Trackers also offer the possibility of high diversification as well as the ability to follow an index of a certain capitalisation, such as small capitalisation stocks, or a sector, such as oil companies, or a theme, such as FTSE4Good. How can advisers use passive investments and recommend them to clients? Advisers can use these investments to form the core of their clients portfolios, to offer a high level of diversification and to reduce the monitoring time that you would have with active funds. The adviser can then concentrate his research activities on the areas of the client s portfolio requiring a higher level of tailoring.

6 Mixed messages In the modern investment environment, putting together the right mixture of passive and active is the key to success Advisers sometimes struggle when trying to explain the merits of passive investing to a client. Why should an investor pay for tracking an index that requires no skill? For that matter, why should an adviser put such an idea forward when it could make his own skills, services and fees look somewhat redundant? In all walks of life, trying to convince someone of a course of action you are not convinced of yourself is a recipe for disaster. Financial advice is no exception, and possibly explains why not as many advisers are using passive investment vehicles as they should be. First and foremost advisers have to get clear in their own minds the benefits of passive investing which is what this supplement is designed for to help them put across a convincing argument to their clients. Why should advisers do this? Put simply, it is no longer a valid argument to say that a client should use either active or passive investments the days of active versus passive are long gone. Investment success is now driven by The merits of passive investing for the reluctant Having a mix of passive and active investment strategies improves potential portfolio success. Index funds do what they say on the tin. Index funds are highly diversified. They give access to the world s major stocks. Index funds have low initial and annual management charges. Invest from as little as 50 per month. HSBC index funds are now S&P AAA rated. getting the balance between these two types of investment vehicles right. The skill of the adviser in achieving this balance is increasingly important. Whether to use passive investment vehicles as the core of a portfolio and use active investments to extract alpha; or whether a client prefers to use passive investing to hedge or risk proof an essentially actively managed portfolio are decisions increasingly put in the hands of advisers. Either way, a mix of active and passive are both key elements to any successful portfolio mix. Taking this as a cocktail analogy, you could say that this approach is not dissimilar to putting together the classic martini getting the balance right between the quantities of vermouth, gin (if you re a purist) and olives is essential. Low cost diversification Tracking an index is often seen as mechanical and not exactly rock and roll, yet there are advantages to having something in your client s portfolio that does what it says on the tin. Not only does this approach help with a client s risk profile but, far from being dull, the diversification potential is endless. An investor can literally invest in the majority of the world s major stocks via seven tracker funds. Hardly vanilla and, let s face it, there are few fund-based investment options that offer investors the ability to profit from the success of companies such as Toyota, Wal-Mart or Total for, in HSBC s case, 0.25% annual management fee, no initial charge and all for as little as 50 per month. Ratings help Whether you agree or disagree with them, ratings have become part and parcel of an adviser s tool kit. Ratings help advisers and their clients to screen the overwhelming number of funds on offer down to a manageable choice. While it often makes sense to look at ratings as an indicator of a particular fund s performance against a benchmark, index funds on the other hand are designed to follow, not beat, their respective benchmark, which means ratings are not really needed. Or are they? The problem is without a rating, a fund simply gets screened out, which makes it difficult for advisers to convince some clients of their potential benefits. This has now changed with HSBC s decision to become the first asset manager to get their index funds rated. All of HSBC s seven index funds have now achieved a AAA rating from Standard & Poor s. This not only means they are on the adviser s radar screen, but it becomes a much easier proposition to put them forward to clients as a potential investment option that has been measured by a reputable third party.

7 Glossary Passive. Passive investing aims to track or match the performance of a particular market as represented by its index. This strategy invests across a wide range of listed shares considered likely to produce a return consistent with the performance of the index they track, rather than beat it through an active investment strategy. A passive investment strategy is generally achieved through investing in index funds. Index Tracking. An index-tracking fund is designed to literally track the performance of a specific stock market index. The fund will hold all or the vast majority of the shares that make up the index constituents providing investors with a performance very close to that of the specific market. See Replication. Tracking Error. This is a measure of the variability of investment returns relative to an index. It is calculated as the standard deviation of the monthly or quarterly relative returns. Replication. An Index fund can fully replicate an index by containing stocks which are in the same proportions to that of the index. Alternatively it can indirectly replicate an index by using financial instruments to track the performance of an index by buying a cross-section of shares that mirror the index. ETF. An Exchange Traded Fund (ETF) is similar to an index fund in that they both track the performance of an index. By investing in an ETF, investors can receive a return that replicates the performance of the index without actually owning the constituents that comprise the index. An ETF is a share which can be traded at any time of the trading day, whereas an index tracker fund is a unit trust which can only be traded at one point in the trading day. ETC. Exchange Traded Commodities and Currencies (ETCs) provide exposure to a growing range of commodities and commodity indices, including energy, metals, softs and agriculture, as well as currencies. ETCs trade just like shares. HSBC INDEX FUNDS Fund Name Charges Min. Investment HSBC FTSE 100 Index Fund (S&P AAA) 0.25% annual, Nil initial 500 additional HSBC FTSE 250 Index Fund (S&P AAA) 0.25% annual, Nil initial 500 additional HSBC FTSE All-Share Index Fund (S&P AAA) 0.25% annual, Nil initial 500 additional HSBC European Index Fund (S&P AAA) 0.25% annual, Nil initial 500 additional HSBC American Index Fund (S&P AAA) 0.25% annual, Nil initial 500 additional HSBC Pacific Index Fund (S&P AAA) 0.25% annual, Nil initial 500 additional HSBC Japan Index Fund (S&P AAA) 0.25% annual, Nil initial 500 additional Forprofessionaladvisersonlyandnotfordistributiontoretailinvestors.The material contained in this document is for information only and does not constitute investment advice or a recommendation to any reader of this material to buy or sell investments. The value of investments, and the income from them, can go down as well as up and is not guaranteed and investors may not get back the amount originally invested. Past performance should not be seen as an indication of future returns. Where overseas investments are held the rate of currency exchange may affect the value of investments. The views and opinions expressed were held at the time of publication and is subject to change. The Funds referred to are sub-funds of the HSBC Index Tracker Investment Funds. The Authorised Corporate Director and Investment Manager is HSBC Global Asset Management (UK) Limited, who provides information to professional advisers and their clients on the investment products and services of members of the HSBC Group. All applications are made on the basis of the current HSBC Investment Tracker Funds prospectus simplified prospectus and most recent annual and semi annual report, which can be obtained upon request free of charge from HSBC Global Asset Management (UK) Limited, 8, Canada Square, Canary Wharf, London, E14 5HQ, UK, or the local distributors. Investors and potential investors should read and note the risk warnings in the prospectus. FTSE, FT-SE, Footsie, FTSE4Good and techmark are trade marks jointly owned by the London Stock Exchange Plc and The Financial Times Limited and are used by FTSE International Limited ( FTSE ) under license. All-World, All- Share and All-Small are trade marks of FTSE. The FTSE 100, FTSE 250 and FTSE All-Share Indices are calculated by FTSE. FTSE does not sponsor, endorse or promote these products and is not in any way connected to it and does not accept any liability in relation to its issue, operation and trading. Approved for issue in the UK by HSBC Global Asset Management (UK) Limited, authorised and regulated by the Financial Services Authority /AS/0510/FP

8 JAPAn Index PACIFIC Index