passive investing *can* beat the index

short_butt_sweet

people often say that passive investing is always beaten by the index, unlike active investing, which offers a realistic chance of beating the index (albeit with a bigger realistic chance of being beaten by the index, and by a bigger margin than passive investing is beaten).

but consider iShares MSCI AC Far East ex-Japan Small Cap ETF (ISFE), which seeks to track the MSCI AC Far East ex-Japan Small Cap Index (you could probably have guessed that ).

since the ETF's inception, it's had a total return of +29.95%, compared to +24.48% for the index. it's also been ahead of the index in most years, so it doesn't look accidental.

how does it do that? well, the OCF is 0.74%, but the securities lending return is 1.02%. so you could say the "effective OCF" is minus 0.28%.

i don't hold ISFE. is it following an index you'd want to track? does securities lending (at least: the way this ETF does it) carry too much risk? but an interesting one ...

Thrugelmir

The obvious disparities are that 1% of the fund is in cash. Also that the fund will hedge it's currency position as is quoted in USD.

MaxiRobriguez

Do people actually say passive investing is always beaten by the index?

There's always going to be small discrepancies between the investment and the index which can lead to slightly higher or lower numbers, but once factoring in costs the probability is you'll come in just under the index.

If you're buying passive investments it shouldn't be to beat an index. You want to be as close as possible - that's what you've supposedly bought. If anything years of over-performance would make me consider selling it. I would be skeptical on the composition of the underlying investments relative to the index and therefore couldn't guarantee future tracked performance, so sell it whilst it's up.

Reaper

There is always tracking error with an ETF compared to an index. That might work for or against you but either way there is no reason to believe it will continue in future.

AnotherJoe

Are you sure its not apparently beating the index due merely to a combination of currency fluctuations? Perhaps you are looking in return in Pounds, whilst its valued in US Dollars, and the underlying index is Yen?

Tom99

I think that particular ETF does not hold all of the stocks in the index just a sample.
Seems to hold about 1,200 stocks, not sure how many are in the index.

short_butt_sweet

certainly there are always minor tracking errors, which can go either way. and unexpectedly large tracking errors (even if they happen to be positive errors) may be a sign that something is going wrong.

however, in this case i think i have a good explanation for the persistent positive tracking error (a.k.a. beating the index). the fund gains extra revenue by lending out some of the securities it holds (1.02% over 12 months, as a percentage of NAV). that more than cancels out the management fees (the OCF is 0.74%). hence it's not surprising that there's a positive tracking error.

securities lending revenue may vary from year to year. so there may not always be the same positive tracking error, and it may not always be positive. but, for instance, look at the tracking error, i.e. the difference between the total return of the ETF and the total return of its benchmark index, by calendar years:

2014: -1.22%
2015: +0.52%
2016: +0.38%
2017: +1.21%
2018: +0.54%

that's based on performance figures in USD, for both the ETF and the benchmark. this ETF doesn't hedge currency (unlike some of blackrock's ETFs).

the "base currency" of the ETF is USD, but that is just for accounting purposes. its assets are 99% in shares which are quoted in a variety of currencies (taiwan dollars, wons, hong kong dollars, etc). the other 1% is in cash (from the list of holdings, it appears to be in a mixture of hong kong dollars, singapore dollars, etc), which will have a minor effect on tracking error.

note that, if you converted the ETF's return figures from USD to GBP, that would give you significantly different figures. and the same goes for converting the benchmark's return figures. but the tracking error - i.e. the difference between the ETF's return in GBP and the benchmark's return in GBP - would be the same as the difference when all figures are in USD. (and incidently, the ETF is traded in GBP on the LSE.)

the ETF holds 1184 securities, compared to 1151 for the index. apparently it's only optimized (i.e. doesn't holding all securities), but it must be near enough. (the 1184 probably includes some trivial holdings for securities which are no longer in the index but are either worthless or too small to be worth selling.)

tin586

Most ETFs lend out stock. It's a bit of a dirty secret, you might say. Stock lending income is also the reason behind the emergence of some fee-free ETFs.

Blackrock (iShares) is more aggressive in this practice than, for example, Vanguard and it can evidently boost returns to investors in the ETF. But it's good for Blackrock as well, as they skim off a significant portion of the lending income before giving the rest to their investors. There is further conflict of interest if the fund manager invests the collateral it has taken from borrowers of stock in money-market funds affiliated to itself.

There is also counterparty risk on the entity borrowing the stock. If there is a borrower default in a time of market crisis, an ETF provider might find that the collateral is worth not much as previously sought.

One has to live with some of these risks (if the alternative is not to invest in ETFs at all). Stock lending income does not seem a convincing reason to choose a particular ETF, given the risks.

Malthusian

Tom99 wrote: »

I think that particular ETF does not hold all of the stocks in the index just a sample.
Seems to hold about 1,200 stocks, not sure how many are in the index.

For a small cap tracker that would be expected. Some of the shares in the index will be too small and illiquid to be worth bothering with. The same would apply to an all share tracker for the same reason (as it includes the small cap index).

Malthusian

MaxiRobriguez wrote: »

Do people actually say passive investing is always beaten by the index?

I have certainly seen it used as a justification for active management.

The problem with the argument is that it is question-begging - in the classical sense. It does not explain why failing to beat the index is a bad thing.

People invest in order to get long term capital growth, not to beat the index. In general (excluding areas like commercial property or smaller companies where passive funds are impractical or a bad idea) passives deliver higher long term capital growth, more consistently, than active funds, due to the inability of fund managers to beat the market consistently.

The fact that passives won't beat the index is not important. It's not a game where getting 8% per annum growth when the index grew by 8.1% means you've lost.