Index Tracker Funds. An Introductory Guide. For professional clients only

Transcription

1 Index Tracker Funds An Introductory Guide For professional clients only

2 HSBC Global Asset Management has a well-established track record in passive investments. It was a pioneer in the UK market launching one of the very first index tracker funds in the country. The world of passive investing has grown and evolved and we have evolved with it. As with any experienced fund provider, over the years we have learned many lessons, honing and refining our product range in the process. This guide highlights some of the key questions that we believe asset allocators should consider before selecting an index tracker fund.

3 What is an Index Tracker Fund? An index tracker fund aims to replicate the returns of a given index as closely as possible, by investing in the securities that make up the given index. A key advantage of this approach, compared to actively-managed funds, which aim to outperform a benchmark, is that it eliminates the risk of significant underperformance of the index in question. Who should consider investing in Index Tracker Funds? Investors who: have a positive long-term outlook for a particular market, such as European or Emerging Market equities would like to take a shorter-term tactical call on a particular market (eg the US or the UK) or a specific sector within a single country (eg mid caps or large cap stocks within the UK market) are comfortable with being tied to the performance of one index prefer the transparency that comes with meticulously following the performance of that index are prepared to take on market risks in order to grow their wealth prefer a more diversified way to invest compared to a focused portfolio or single stocks do not feel comfortable with entrusting the performance of their portfolio to a fund manager aiming to deviate from the performance of the underlying market Sticking with the market An index fund will provide exposure to individual constituent companies and their industries in the proportions in which they are reflected in the index. Hence the performance of any index constituent would be reflected equally in the performance of both the underlying index and the index fund. An index fund manager will not vary the fund weights from the underlying index and will not, for example, increase its exposure to cash if the market is expected to fall. Equally, index fund managers will not seek to vary exposures to certain companies or whole sectors in order to reduce concentration risks. For example, three energy companies and five banks make up 24.4% of the FTSE 100 Index 1. Depending on the outlook for the energy sector and other areas of the underlying market, the level of risk in an index fund will rise or fall in line with the risk in the Index and the manager will have no discretion to vary that. 1 The three oil & gas sector constituents accounted for 13.1% and the five banking sector constituents accounted for 11.3% of the FTSE 100 Index as at 29 April Source: FTSE. Guide to Index Tracker Funds 3

4 Choosing the right index Different index providers have different criteria for including stocks. Subsequently, indices are not the same. While some indices may cover the same region, country or an asset class as a whole, differences in classification and rules often lead to differences in composition and performance. Ultimately, there are no rules set in stone on how stocks should be categorised. Hence, there is a degree of subjectivity in how each index provider chooses to represent a certain market. Investors must be mindful that while some indices may have similar names and would seem to reflect the composition and performance of the same market, their risk and return characteristics can be different. For example, some providers, such as MSCI, include Real Estate Investment Trusts (REITs) and preferred shares with equity characteristics in their indices. In contrast, FTSE does not consider those investment securities, which in this instance would lead to a smaller property sector exposure. Providers also use different methodologies to identify and separate large cap stocks from the rest. A number of indices automatically exclude newly-listed companies, while requirements in respect to the level of liquidity for a stock can also be different. may vary in terms of the investment universe they cover. For the following illustration, we have used a real-case example of two existing US equity index funds from well-known providers. While both funds seem to track the US equity market, one of them uses the S&P 500 Index, while another is based on the FTSE North America Index, where Canada accounts for 5.2% of that index 2. The S&P 500 Index is believed to be one of the best representations of the US stock market and a bellwether for the US economy. Given the indices geographic mismatch, there have been notable differences in their exposures to several sectors, which in turn has impacted performance. As can be seen in the following chart, the financial sector accounted for 1.83% more of the FTSE World North America Index compared to the S&P 500 Index. The healthcare sector accounts for about 1% more and information technology for 0.71% more by capitalisation within the S&P 500 Index compared to the FTSE World North America Index. As a result, the S&P 500 Index returned 73.0% over 5 years, compared to 63.5%% for the FTSE World North America Index. In turn, this means that US equity index funds, for example, that track different indices will differ in terms of their short-term volatility and long-term performance. While two index funds might have similar names, sometimes their underlying indices 2 Monthly factsheet for the FTSE North America Index as at 29 April 2016 S&P 500 Index vs FTSE North America Index: Differences in sector exposures S&P 500 Index vs FTSE North America Index: Performance 1.50 % Difference Consumer Discretionary Consumer Staples Energy Financials Health Care % Difference Industrials Information Technology Materials Telecommunication Services Utilities YTD % Change One Year % Change Three Year % Change Five Year % Change S&P 500 Index FTSE North America index Source: Factset as at 31 March 2016 Source: Factset as at 31 March Guide to Index Tracker Funds

5 Why is there a difference in performance of an index fund compared to the index it tracks? Regardless of the index a tracker fund tries to replicate, there will always be some difference between the performance of the fund and its underlying index. In absolute terms, this is known as tracking difference, or a tracking error if it is measured over a period of time. This is because all replication methods incur some dealing and trading fees as portfolios need to be periodically rebalanced to accurately reflect the composition of the index being tracked. The resulting costs are deducted from fund returns. That said, it is worth bearing in mind that larger passive fund managers are able to achieve greater economies of scale, which can lead to lower costs for clients. Global passive fund managers also need to maintain and develop relationships with traders and brokers around the world, to ensure best execution and low trading costs. It is also in passive fund managers interests to have a local presence in key global trading centres, so they can keep up to date with changing regulations and understand exactly how local markets work. How is index performance replicated? There are two main methodologies used by passive investment providers to replicate an index, with different techniques applied to minimise tracking error. The most straight-forward way of achieving that objective is physical replication. In this instance an index fund manager purchases the underlying assets of an index. We believe that this is the best approach to take, as it allows us to construct funds with a high degree of transparency and simplicity, without compromising their ability to track an index closely. When buying all of the securities in the underlying index is not cost-effective, such as in the case of broadly-based indices such as the MSCI World or the FTSE All Share, fund managers can use a process known as optimisation. In this case only a proportion of securities in the underlying index is bought. An alternative to this is synthetic replication, whereby a fund manager instead buys a swap from a third party, a derivative security providing the index return from a given index in exchange for a fee and any returns on collateral held in the fund. Although some studies have shown that synthetic funds can offer a lower tracking error over time than full physical replicated funds, we believe that the risks associated with such synthetic funds the most important of which is counterparty risk make them a less attractive investment option. We also believe that investors are not being compensated for this type of risk. The table overleaf shows some of the main replication strategies used in the construction of index tracker funds: Full Physical Definition Advantages Disadvantages Investment made in every constituent of the index proportional to its market share Cash flow management Very low tracking error Full transparency Custody costs ` ` ` Transactions costs ` Withholding tax Optimised physical Optimisation allows the portfolio to match the basic characteristics of the index using a multi factor risk model. It is often used for broader indices Works well for small funds Efficient in liquid markets Lower custody costs Potentially higher tracking error Increased volatility risk Re-optimisation costs Synthetic Uses derivatives (mainly stock index futures, swaps and OTC contracts) to mimic the benchmark s performance Low custody costs ` Low tracking error ` Minimum transaction costs Swap counterparty risk Non transparent ` ` Variable swap fee can affect tracking error Guide to Index Tracker Funds 5

6 What should I look for in a passive fund provider? There are several key factors to consider when choosing the right passive fund provider for your and your clients investment needs: Experience Scale Index methodology Tracking performance / tracking error Costs Commitment to innovation HSBC: A proven track record Given that tracker funds are quantitatively-driven investment vehicles, it can be argued that they are only as good as the processes and technology behind it, backed by knowledge and expertise of the fund provider. HSBC Global Asset Management is a UK pioneer in index funds, having launched its first tracker in Since then, we have been perfecting our investment models and developing products in this area. Present in more than 20 countries and territories around the world, we manage over 800 funds run by our passive and active investment management teams. We use our global footprint to devise cost-effective and focused passive investment products. Our passive investment team has full support of HSBC s infrastructure and expertise, and our integrated systems help to minimise client costs through efficient execution and portfolio management. Our focus remains on delivering highly competitive and transparent index solutions based on robust design and high governance standards. We believe that we are in a very strong position to lead in passive investment in the years to come. 6 Guide to Index Tracker Funds

7 Key Risks Market risk: The value of investments and any income from them can go down as well as up, and investors may not get back the amount originally invested. Investment horizon: Stockmarket investments should be viewed as a medium to long term investment and should be held for at least five years. Currency risk: Where overseas investments are held, the rate of currency exchange may cause the value of such investments to go down as well as up. Emerging market risk: Investments in emerging markets are by their nature higher risk and potentially more volatile than those inherent in some established markets. Geographic risk: Some of the funds invest predominantly in one geographic area; therefore any decline in the economy of this area may affect the prices and value of the underlying assets. Performance risk: Past performance is not an indication of future returns. Guide to Index Tracker Funds 7

8 Contact For more information, please contact us: Telephone: Website: Important Information This document is intended for Professional Clients only and should not be distributed to or relied upon by Retail Clients. The HSBC index tracking funds referred to overleaf are sub-funds of HSBC Index Tracker Investment Funds, an Open Ended Investment Company that is authorised in the UK by the Financial Conduct Authority. The Authorised Corporate Director and Investment Manager is HSBC Global Asset Management (UK) Limited. All applications are made on the basis of the HSBC Index Tracker Investment Funds prospectus, Key Investor Information Document (KIID), Supplementary Information Document (SID) 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 and relevant KIID and additionally, in the case of retail clients, the information contained in the supporting SID. The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested. Where overseas investments are held the rate of currency exchange may also cause the value of such investments to fluctuate. Stockmarket investments should be viewed as a medium to long term investment and should be held for at least five years. HSBC Global Asset Management (UK) Limited provides information to Institutions, Professional Advisers and their clients on the investment products and services of the HSBC Group. This document is approved for issue in the UK by HSBC Global Asset Management (UK) Limited who are authorised and regulated by the Financial Conduct Authority. Copyright 2016 HSBC Global Asset Management (UK) Limited. All rights reserved CP/0616/FP until 07/12/2016. Index disclaimers FTSE is a trade mark of the London Stock Exchange Group companies, NAREIT is a trade mark of the National Association of Real Estate Investment Trusts ( NAREIT ) and EPRA is a trade mark of the European Public Real Estate Association ( EPRA ) and all are used by FTSE International Limited ( FTSE ) under licence. The FTSE 100 Index, FTSE 250 Index and FTSE All Share Index are calculated by FTSE. Neither FTSE, Euronext N. V., NAREIT nor EPRA sponsor, endorse or promote this product and are not in any way connected to it and do not accept any liability. All intellectual property rights within the index values and constituent list vest in FTSE, Euronext N.V., NAREIT and EPRA. HSBC Global Asset Management has obtained full licence from FTSE to use such intellectual property rights in the creation of this product. Standard and Poor s 500 is a trademark of The McGraw-Hill Companies, Inc. and has been licensed for use by this Fund. The Fund is not sponsored, endorsed, sold or promoted by Standard & Poor s and Standard & Poor s makes no representation regarding the advisability of investing in this Fund.