Systematic index-plus funds and even some dedicated passive vehicles are being hampered by UCITS rules confining them to the same rules as active funds, according to Matt Tagliani, head of EMEA ETF product at Invesco.
The rules currently employed state that active funds must adhere to a 5/10/40 rule, where a fund can hold up to 10% in one individual stock and can hold no more than 40% in companies with a weighting above 5%.
Conversely, passive funds can have as much as 20% in any company and 35% in one stock under exceptional circumstances.
But not all passive funds benefit from this, said Tagliani, as these rules only apply to vehicles that use full replication, where the fund buys every single stock (or bond) in the benchmark at the same proportion as the index.
Some exchange-traded funds (ETFs) use optimised sampling, a method where a smaller basket of stocks is used with the idea of matching the index’s key risks.
This happens in a lot of cases “if the full benchmark is not completely replicable”, said Tagliani. “So it [the 5/10/40 rule] still applies to passive funds, in the subset of cases where you're using optimised sampling,” he said.
The rules, he argued, are stricter for active managers because these funds are run by someone who can “select whatever” they want, while an index fund is beholden to a prospectus and must be transparent with what it will hold.
“You're guarding against a manager who's having a bad month, who's got a strong view on a particular stock, and says, 'Well, I'm going all in on this thing to try to turn around my performance’,” he said.
"Most managers are not going to [behave] this way, but the regulator has to watch out for a manager having a bad run and then doubling down on their best idea.”
Active funds typically disclose their holdings monthly or quarterly, Tagliani noted, meaning "no one's going to know for the next 15, 20 days" if a manager has made a concentrated bet. This is opposite to passive funds, where positions change gradually and are visible continuously. A stock is unlikely to go from 5% to 10% overnight, he noted.
Yet they can be caught up in the same rules applied to active funds. As can index-plus funds, also described as systematic, tilt or smart-beta funds.
These portfolios replicate an index before making tiny marginal calls – sometimes basis points – on stocks in an attempt to beat the benchmark.
This is a live issue for Invesco. Tagliani pointed to the firm’s Global Enhanced strategy as an example. The fund looks to deliver returns marginally ahead of the MSCI World. Its sector positions can never be more than 2 percentage points different from the index, targeting a tracking error of 1.5%.
He described the fund as a “hair's breadth” from being passive but noted that it is “classified as active” and, as such, is “immediately tied to these [active UCITS] constraints”.
These funds are growing in popularity, with Tagliani pointing to the rapid growth of benchmark-aware strategies, so now could be a good time to find a regulatory solution that works for these ‘hybrid’ funds.
One option is a benchmark-referenced set of rules that would allow funds to overweight stocks by a set percentage, say 2 percentage points. This would allow active funds to overweight a stock where appropriate, while also giving a limit to off-benchmark companies and small stocks in the index.
“Our current regulatory framework only really considers these two extreme cases. I think there's a clear logic to a middle ground,” he said.
“I think it's entirely a coherent concept to say, I'm going to have a benchmark-relative fund, where I want to have the same ability to go up to whatever the levels are in the benchmark. That's quite an interesting idea.”
He noted that this will be “much more challenging to monitor” than the current rules as both sides of the equation will be moving. A fund’s individual position could rise more if the stock does well, while the underlying weighting of the index will also change at the same time.
“The weighting in your portfolio would have to constantly be adjusted. It's a challenging thing for us to operationalise because the weights of the things you're referencing are constantly moving. But I think that's actually quite interesting.”
Ultimately, the regulator will not decide this based on what asset managers want, but on what is best for the end retail investor. Here, Tagliani noted that there is clear demand for systematic or quantitative index-plus funds.
He said the case should be framed to the FCA in terms of investors' interests, with a framework that lets these strategies replicate the benchmark closely while making minor tweaks.
“Those of us who do it better, and those of us who do it worse, will have more or less success but it's not about what we want, it's what retail investors want. I think that's the key point,” he concluded.
Yesterday, Trustnet looked at the issue active managers face when adhering to UCITS rules that do not allow them to overweight certain stocks. In the next article in this series, we look at investment trusts and why they are able to invest freely.