Passive funds require robust due diligence

Advisers and consumers should complete thorough due diligence before investing in ETFs or passive funds, TCF Investment warns.

The asset management firm says there is an assumption that indexed investment vehicles only involve the beta risk of the markets they track, which is not the case.

TCF Investment joint founder and CEO Gary Mairs says there are five key areas, aside from costs and total expense ratios, which advisers need to check before investing. These comprise index suitability, stock lending, vehicle structure, engineering and tax.

The first step is for advisers and investors to understand the characteristics of the underlying index being tracked, and how the ETF mirrors the index. For example, the ETF can use full replication by investing in the index constituents, or synthetic replication, using swaps to return the performance.

TCF says full replication can incur a drag from the transaction costs of buying and selling the underlying index constituents, which can have a bigger impact on smaller funds.

The firm says in terms of synthetic replication, there is a level of credit risk with the swap counterparty. Investors must take note of this and the potential risks relating to the collateral management process.

Similarly, the practice of stock lending, whereby the ETF manager lends the fund's assets to a third party in return for a small fee, is an important consideration, especially as this can entail further credit risk.

The amount of the fee that is returned to the fund and shared with the manager can also vary, which investors must take into account.

TCF Investment joint founder and CEO David Norman says: "Low cost, well diversified, passive portfolios that are matched to investors' risk/return profile can offer the best expectation of superior investment return.

But, as with many financial instruments, it is important that appropriate due diligence is conducted before investing."