For professional clients only

for Index Tracker Funds and ETFs

Importance of Due Diligence

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2 Importance of Due Diligence

Passive funds may differ from active funds in the way they are

managed, structured and traded but products from different

providers may vary just as much as active funds. In order to

incorporate high quality passive funds into a portfolio, they

will need to be evaluated just as thoroughly and diligently as

active funds.

Due diligence processes in relation to passive investments are

still in their infancy, even though they are already an established

part of investors’ tool kit. For example, 90% of UK wholesale

investors we questioned recently1 invest in passive funds but

30% do not have specialised due diligence procedures for

Exchange-Traded Funds (ETFs).

Lack of due diligence may lead to elevated concentration risks of

having too much exposure to a single fund provider. When asked

to consider whether having a high proportion of assets invested

with a single provider of passive funds posed a risk, 68% of UK

intermediaries agreed. And yet, 54% of them did not impose

limits on how much single exposure they may have. Out of those

providers that did have exposure limits to a single provider, 18%

had different limits for passive fund providers compared to those

for active fund providers.

As awareness of issues such as concentration risks becomes

more prevalent, we expect to see better due diligence used in

the selection of passive funds. We believe that fund selection

based on strong risk assessment and due diligence, rather

than going for a ‘default provider’, will ultimately lead to better

outcomes for end investors.

In this flyer, we will cover some of the most important

questions that, in our view, intermediaries and fund buyers

should address as part of their due diligence framework for

passive fund selection.

DUE DILIGENCE

Risk management?

Tracking difference?Index coverage?

Tracking error?

Costs?Replication?

Experience and brand?

Liquidity?Independent ratings?

Making the right choiceAs part of passive fund selection, due diligence is typically

conducted in three stages. First, suitable indices are identified,

then beta vehicles tracking them, with the final selection based

on the choice of provider(s).

The different considerations at each of these levels are weighted

depending on advisers’ views on the following key factors.

Underlying index and its coverage Each index has its own construction methodology which

determines which stocks are included from their respective

investment universe. Different index providers covering the

same market would not normally have the same stock selection

criteria. Some equity index providers would exclude certain types

of shares, while others will not or classify sectors differently

from other providers. Some indices may exclude whole countries

from their scope, while other providers will include them. The

most commonly used index selection criteria takes into account

market capitalisation of the underlying securities.

Liquidity of the underlying market When selecting a passive fund, investors should consider the

level of liquidity (availability) of the underlying index’s constituent

securities. Some types of securities, such as those issued by

smaller companies, may be less liquid than others.

Physical or Synthetic Replication?The most straight-forward way to replicate an index is physical

replication. In this instance, an index fund manager purchases

the underlying securities of an index.

An alternative to this is synthetic replication, whereby a fund

manager instead buys a swap from a third party. A swap is a

derivative security providing the return from a given index in

exchange for a fee and any returns on collateral held in the fund.

There are concerns that the risks associated with synthetic funds

– the most important of which is counterparty risk – can make

them a less attractive investment option. It means that investors

may not be compensated for this type of risk.

Overall cost When it comes to comparing fund costs, it is increasingly based

on passive funds’ total cost of ownership. This way, a comparison

takes into account not only management fees and the Ongoing

Charges Figure (OCF), but also transaction costs.

Mind the gap

1 Source: HSBC Global Asset Management Passive Investments Client Survey, September 2014

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Importance of Due Diligence 3

The total cost of ownership comprises:

` Costs of holding the fund (which effectively are reflected

by the fund’s tracking difference) – consists of the OCF

and the costs incurred within the fund, such as rebalancing

costs, taxes, dividend reinvestment/cash drag and any costs

associated with the optimisation, if applicable.

` Costs of trading the fund – where applicable include

platform or brokerage transaction fees and taxes.

Tracking difference and tracking errorPassive funds’ dealing and trading fees mean that they never

mimic their index exactly. Two measures used to gauge this

discrepancy in returns are ‘tracking difference’ and ‘tracking

error’. These measures should be considered together as tracking

difference looks at how well an index is replicated over a given

period of time, while tracking error, being a measure of volatility,

gives an idea how consistent that replication is.

Larger providers often are able to minimise these costs through

economies of scale and this factor should be considered as part

of a due diligence process.

Moreover, when comparing tracking errors of different funds,

investors should bear in mind that different providers may price

their index funds at different times of the day. It means that

the figures may need to be adjusted before a fair comparison

is made.

Risk ManagementAsset managers must be judged on their ability not only to

monitor but also to control a range of risks that may affect

their passive funds’ ability to track indices effectively. Risk

management is a key consideration not only during portfolio

construction but throughout the life of the fund.

Ongoing risk management includes the analysis of performance

attributions and exposures to different parts of the underlying

market. Asset managers also look at the impact of index

rebalancing, currency exchange rate exposure and corporate

actions, such as mergers and acquisitions, stock splits, rights

issues, spin-offs or the receipt of interest and dividends.

Many fund providers use stock lending which helps to reduce

fund costs by lending some of the portfolio holdings to a third

party for a fee. However, it carries some risk, as the stock maybe

lost if the counterparty goes out of business. Some providers

indemnify their investors against this risk while others don’t, so a

review of stock lending practices should form an important part

of any due diligence process.

Other important risk factors that asset managers always need

to take into consideration are regulation and tax regimes,

which may span many countries and continents depending on

the investment universe of a given fund. Changes to tax and

regulation may have an impact, sometimes considerable, on the

performance of the underlying funds.

Experience and brandIt may be argued that, being quantitatively-driven investment

vehicles, passive funds are only as good as the processes

and technology on which they are built. In addition, the track

record and reputation of the fund provider also offer an effective

reflection of the asset manager’s capabilities, knowledge

and experience.

Independent ratingsAs with active funds, there are a number of independent ratings

agencies that assess passive funds’ relative performance,

together with the strength and quality of their investment

processes.

Independent ratings are designed to help investors decide which

funds have the greatest potential to deliver the best performance

in the future.

Please see a range of our thematic flyers for more detailed

information on some of the key questions outlined here.

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ContactFor more information, please contact us:

Email: broker.sales@hsbc.com

Telephone: +44 (0) 207 024 0435

Website: www.assetmanagement.hsbc.com/passive

Important InformationFor Professional Clients only and should not be distributed to or relied upon by Retail Clients.

The material contained herein is for information only and does not constitute investment advice or a recommendation to any reader of this material to buy or sell investments.

This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe to any investment.

Any views expressed were held at the time of preparation and are subject to change without notice. While any forecast, projection or target where provided is indicative only and not guaranteed in any way. HSBC Global Asset Management (UK) Limited accepts no liability for any failure to meet such forecast, projection or target.

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. Investments in emerging markets are by their nature higher risk and potentially more volatile than those inherent in some established markets. Stock market investments should be viewed as a medium to long term investment and should be held for at least five years. Any performance information shown refers to the past and should not be seen as an indication of future returns. Some of the ETFs 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.

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