Yahoo Finance This is exactly what happens when you invest your money in a tracker fund
The rising popularity of “passive” investing has seen savers put hundreds of billions of pounds into cheap tracker funds. These funds allow you to invest in the FTSE 100, for example, for less than 0.1pc a year.
There is a general assumption that, relative to stock picking, tracking an index is a simple task that can be run entirely by computers. But what exactly happens to your money when you put it into a tracker fund?
Telegraph Money spent a day at the London offices of Vanguard, the world’s second largest asset manager – and a major proponent of passive investing – to find out.
It’s not all computers – but there aren’t many people
Vanguard’s trading floor is not a row of computers. The desks are occupied by people, albeit just a small number of them managing an astronomical amount of money. The space is compact – and quiet.
Vanguard’s equity index group, the people involved in actually running its stock index tracking funds, consists of 60 people: 35 portfolio managers, plus traders, analysts and those in leadership positions.
Between them they run £1.9 trillion, spread across a few hundred portfolios. That equates to £32bn per person. There is no one set manager per portfolio, and responsibilities regularly rotate.
On the bond side, more people are required. In the fixed-income group there are 160 people managing £900bn. There are still only 45 portfolio managers, but more than 100 traders and research analysts are needed.
These teams are spread across the company’s US, European and Australia-Pacific regions, surrounded by the thousands of other staff who make up the Vanguard machine.
The end investor is discussed frequently, but handling incomprehensibly large amounts of money is part of the day-to-day. One member of the foreign exchange team said she put through more than £100bn in currency orders last month.
What actually happens to my cash?
A surprising amount of spadework is involved in following an index.
Say you give Vanguard £1,000 to put into a fund that tracks an index of 100 stocks or 100 bonds.
It’s easy to imagine a computer algorithm splitting up that £1,000 neatly and buying £10 worth of each stock or bond. Then, as the index changes, the algorithm makes the necessary updates.
For a host of reasons, including transaction costs, access to certain markets and liquidity, that isn’t possible or efficient.
Instead, your money is pooled with all of the other money the firm takes in. Portfolio managers then work out – with the help of many digital tools – the most efficient way to invest that cash to keep a tracker fund in line with the index in terms of performance and risk, while keeping trading costs to a minimum.
While active managers compete on performance, passive managers compete on “tracking error” – the accuracy with which their fund tracks the relevant index – and at Vanguard their pay is based on it too.
A tracker fund can deviate from an index for a number of reasons, including trading costs and accounting technicalities.
In some cases, a tracker’s holdings may not actually match the index exactly. Its job is to deliver the same performance as the index without taking extra risk, which can be possible without exactly replicating it.
Melissa Tuttle, a senior equity portfolio manager, said her team tended to use incoming cash to top up holdings that had ended up “underweight” compared with the index. Their aim is always to fully invest new cash.
Events such as the FTSE 100’s quarterly review, when companies enter and leave the index, also have to be anticipated, and predictions made.
Combining trades together keeps transaction costs down. If 11 different Vanguard trackers need to buy HSBC shares, there is little point in them doing so separately.
Portfolio managers put in orders, which are then carried out in whichever region the stock in question is listed in. If a manager in London needs to buy Apple stock, the order is sent to the US team and bundled with any other Apple orders.
That said, Vanguard is clearly pushing to automate as much as possible. “It’s fair to say we’re growing systems now, rather than people,” said Dr Alla Kolganova, head of equities for Europe.
With shares, 95pc of trading is carried out electronically, with a high degree of automation.
There is still 5pc where a portfolio manager may have to go hunting for a broker, however – particularly in the more difficult-to-access markets such as the Middle East. In some cases, this could still mean picking up the phone.
On the bond side, things are different.
Paul Malloy, Vanguard’s head of fixed income in Europe, said only 5pc of bond trading had been significantly automated – largely for small trades in highly liquid government bonds.
The other 95pc is still done “over the counter” – meaning between two parties away from a stock exchange.
“Bigger trades, or trades in less liquid areas such as corporate bonds or emerging markets, still require picking up the phone or some sort of electronic auction. There’s still someone on the other side,” Mr Malloy said.
He added that, thanks to the sheer number of bonds being issued and the number that have relatively little trading activity, buying every single bond issued by every single company in an index would incur huge costs.
Instead, his team buy samples that represent the index, balancing tracking error, risk and cost.
“You need to own about half the bonds in an index, representing about 95pc of the companies. We don’t need to own every JP Morgan bond to track the index – I can pick the one I like best. It’s a lot like active management, but you’re controlling risk and cost to avoid losing value, rather than trying to add value,” he said.
Risk
Sitting between the equity managers and the bond managers - both passive and active - is the risk team.
Brian Wimmer, head of risk management for Europe, said there is a slim initial tolerance for a fund being out of line with its benchmark index. If that figure is breached “a conversation starts” – and there is then an absolute maximum tolerance allowed.
This team is also in charge of ensuring that no financial regulations are breached.
Colour-coded systems are used to keep track. Today, everything is running smoothly for the firm’s LifeStrategy range of ready-made portfolios.
When something is out of line, analysis tools enable a risk manager to look at where that error is coming from, and action can be taken to push things back into line.
One option at Vanguard’s disposal is to suggest changes to an index itself, through its relationships with index providers, when it thinks improvements can be made.
Follow us for more investing ideas: @TelegraphInvest
For investment tips and ideas five days a week, read Questor
