For some time now, the implementation of passive mandates has been a rising trend amongst pension funds. Background of this raising trend in passive investing amongst pension funds is the ongoing efficiencies on markets where the underlying titles of a benchmark are traded and the relative low costs of such mandates. Passive investments, as opposed to active investments, involves investing based on a benchmark. In this way of investing, the benchmark is 'followed' by buying the various securities of which the benchmark consists. There are many different forms of passive investing, as well as there being hybrid forms in which a portion of the portfolio consists of actively manged positions combined with following a specific the benchmark. Additionally, there are also forms in which 'passive' investments are made in predefined sectors or areas of interest (‘factor investing’).
27 Aug 2019
In this article, I focus on passive investing in the purest form of this investment style: following a pre-selected benchmark without any deviation from this benchmark.
In the case of passive investments, a rough distinction can be made between a discretionary passive mandate and a fund structure with a passive investment style.
For many pension funds, the liquidity of investment funds and the opportunity to follow a (comprehensive) benchmark using a relatively simple method and with a relatively small investment size is the reason for choosing an investment fund over having their own passive segregated mandate. However, an investment fund structure provides little or no flexibility for the pension fund to determine matters for itself or for the pension fund to benefit from a specific tax status.
When you choose an investment fund, there are a number of points that you, as a pension fund, need to consider and have a well-founded opinion on from a risk management perspective.
Below we investigate the four most important points to consider when investing in passive investment funds.
1. Full replication or synthetic positions:
Is the index that is followed by an investment fund fully replicated? In other words, does the fund actually have all the underlying securities of the index or are derivatives used to create positions in a 'synthetic' manner? If no derivatives are used to create (synthetic)positions, is it as well possible that derivatives are used to leverage the fund?
Synthetic positions or the use of leverage is no problem if you, as a pension fund, are aware of the use of derivatives, you understand how the derivatives are used and if the use of derivatives is allowed for in your investment policy/risk framework. However, based on your risk framework and/or investment restrictions, synthetic positions, or having leverage, may not be permitted, which means that by investing in certain passive investment funds you may not comply with your own investment policy!
2. Securities lending
In many investment funds the prospectus allows for the lending of the securities in the fund to other parties in the market – this is called Securities Lending. There is nothing unusual about this and the securities lending market is still very large and plays an important role in creating liquidity in markets. As a pension fund, however, you should ask yourself whether securities lending is permitted in your investment portfolio on the basis of your investment policy. Because despite the fact that securities lending occurs on a large scale, there are good arguments for you as a pension fund to exclude securities lending in your investment portfolio.
If lending securities is permitted under the pension fund's investment policy, it is still advisable to take a closer look at what is happening within the investment fund; especially at the fee split that is used. The fee split is defined as the portion of the proceeds from the lending of securities that benefits the investors in the fund and the income from securities lending that flows back to the fund manager. When assessing the fee split, you must balance whether the risks for you as an investor in the fund outweigh the income from securities lending.
Additionally, you could consider whether the fee split is a fair distribution of the securities lending income, according to your own standards.
Also have a look at which collateral is allowed to mitigate risk of the lending transaction. It is normal for parties to exchange collateral based on the daily value of the securities that have been lent to a counterparty, to mitigate counterparty risk. But if the ‘quality’ of the received collateral is not a fit with allowed investments as stated in your investment policy, you are not complaint with your own policy and there could be additional risk. Additionally, look at the collateral process, is collateral received on a segregated account, is received collateral reinvested in some way or maybe even lent out again
Finally, it is possible that the extra income from securities lending is not included in the benchmark that is followed by a fund. If this is the case the securities lending income can have a positive effect on the performance of your fund compared to the index and might even create outperformance and trigger performance related fees.
3. Proxy Voting - use your voice
Many investment funds with an ESG focus vote on the basis of the fund's ESG policy at the shareholders' meetings (‘proxy voting’) of the companies included in the fund. However, the ESG policy followed of the fund, and specifically the voting policy, needs to be aligned with the ESG policy and/or convictions of your pension fund. Any discrepancy between your own policy and the policy of the fund can cause problems in the governance of your pension fund and with the accountability towards your members.
4. Tax exemption and repayment
Perhaps the most important financial point to consider is how an investment fund deals with tax deductions, tax exemption and tax repayment to understand to what extent there is ‘dividend leakage’.
Since many investment funds are registered as a foreign investment entity (domiciled in Ireland or Luxemburg for instance), there are many cases where the tax status of the investment funds domicility is favourable for the investor. However, an investment fund remains a fund structure in which there is typically no fiscal transparency (the underlying investors are not known to the tax authorities). This means that as a pension fund the withholding tax on dividends may not be settled at the 0% tax rate that applies to pension funds in (for instance) the Netherlands. Instead, a higher rate may be applied. The difference between the applied tax percentage in an investment fund and the applicable tax rate on you as a pension fund is referred to as dividend leakage.
Including the consideration and extent of dividend leakage as part of your decision process to invest in an investment fund is very important, as dividend leakage can amount to considerable sums of money. When including dividend leakage as part of your investment decision the true costs of using a fund for a passive investment strategy can suddenly create a different view on the investment costs quoted by a fund.
With the introduction of Index Custody, we offer pension funds an innovative way to have the best of both methods of passive investing!
With Index Custody by KAS BANK, the content of a specific benchmark (the is selected by the pension fund) is physically replicated via an innovative and automated infrastructure. After the replication all the underlying investments of the benchmark are held in custody in the name of the pension fund. Adjustments to the content of the benchmark are automatically executed, so even though you own the underlying investments of a benchmark you still benefit from automatic benchmark tracking.
Our Index Custody solution is not organised within a (‘market-traded’) fund structure but is a segregated and discretionary portfolio in the name of the pension fund. As a result, you as a pension fund have full control over and transparency in the contents of and adjustments to the benchmark and/or the mandate, without this being complicated or expensive. Additionally, with Index Custody by KAS BANK there is no need to appoint an asset manager. All trading takes place on an execution only basis and on an automated basis which saves fees and makes the role of the asset manager obsolete. There are additional advantages as well. These include, for example, applying a specific ESG policy to a commonly used benchmark (such as the MSCI World), voting at shareholders' meetings based on your pension fund specific ESG policy and/or conviction, determining the restrictions of and negotiating the fee split securities lending. But above all, there is the advantage of minimising the dividend leakage in your investment.
By using our Index Custody service, you can benefit from the best of both worlds; with the advantages of a discretionary mandate and from the characteristics that make an investment fund so interesting as an investment type.
If you would like to discuss passive investing and/or our Index Custody services please contact me, Matthijs Verweij.