Return opportunity presented by structural beta

Excluded Indexed Securities could become the next big thing for investors looking for improved returns from passive funds.

For right or wrong, it’s an incontrovertible fact that more and more investors as well as their advisers are making the shift to using passive funds as part of their diversified portfolios.

What is motivating that shift varies enormously based on individual tastes and preferences. Some investors are very focused on lower costs, whilst others want to escape the idiosyncratic risk of relying on an active stock picking fund manager.
Whatever the exact motivation, inflows into Exchange traded funds and index tracking unit trusts continues to grow at a much faster rate than mainstream, actively managed funds.

This shift has brought increasingly frenzied debate about the true level of counter party risk and the potential threats posed by stock lending. But these debates – though absolutely important – are just the tip of a much bigger series of questions that surround passive funds.

Investors need to think long and hard about the sustainability of individual funds, especially ETFs. In the US, more and more exchange traded fund providers are choosing to cull their range of funds as assets under management fail to make the grade. Who wants to be in a small fund, about to be closed, with the potential for closure expenses charged to NAV ?

Investors also need to be thinking long and hard about liquidity and bid offer spreads for on-exchange products – as well as whether platform providers will actually provide trading access to funds. And finally, the choice of index is absolutely crucial. What exactly is your index tracking? Is the index ‘well constructed’ or too risky? There are no right or wrong answers to these questions, just the necessity for more questioning and due diligence.

There’s also the issue of structural beta. This refers to debate on how to improve returns from tracking a leading benchmark, using more ‘creative’ structures.

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