Why invest in closed-ended trackers

David McCraw, manager of the Edinburgh UK and US Tracker trusts, explains why passive strategies work well for investment trusts.

There is no right or wrong answer in the active versus passive debate and investors’ preferences will depend on their objectives and risk appetite. Active and passive investment strategies need not be regarded as mutually exclusive but potentially complementary.

It is understandable that many investors may be reluctant to give up the potential outperformance of active management. However, the benefits of lower fees and greater certainty offered by indexed management also has its attractions and many investors are choosing a passive core for their investments and then adding active funds, providing more specialist or higher risk strategies, as satellite portfolios.

Match the benchmark

The objective of an index fund is to match as closely as possible the return from the relevant benchmark index. There are many ways to build an indexed portfolio but, like all other equity funds, there are costs that are related to the management of the portfolio – in the case of index funds, these costs relate mainly to transactions within the portfolio. The index does not suffer transaction costs, which the index fund has to bear, and therefore the ability of the index fund manager to minimise costs is a key function.

The tracking error

The measure of success of an index manager is the difference between the performance of the fund and the return from the index – the tracking error. Determining an acceptable tracking error will in turn influence the most appropriate index-tracking strategy, which will usually be based on either full replication, stratified sampling or optimisation strategies which are explained below.

The strategy used to build a portfolio for an index fund is therefore driven by the need to match likely transaction costs with expected tracking error.

The key difference between index funds and actively managed funds is the objective of an index fund is to track the index rather than to outperform it. This means totally different techniques are required to run index funds. After having established the benchmark index to track, the following are the main factors in managing an index fund:

• Select a reliable indexation strategy;
• Construct a portfolio of stocks that will track the performance of the index;   
• Purchase the relevant shares as cheaply and efficiently as possible;
• Monitor the portfolio to ensure that it tracks the performance of the index;
• Adjust the portfolio to reflect changes in the index.