Take the example of the German Dax, the benchmark index of the Frankfurt Stock Exchange. To calculate this index, the Frankfurt Stock Exchange takes into account the stock prices of the 30 largest German companies whose shares are most traded at the Exchange.
The weighting of each of these companies in the composition of the index depends on the daily trading volume and the number of shares in circulation. Thus, the weight of the insurance company Allianz is 7.97% for example, that of the automobile manufacturer Daimler 8.11% and of the semiconductor producer Infineon Technologies 1.68% *.
To replicate the DAX index, the manager is going to invest 7.97% of the collected funds in Allianz shares, 8.11% in Daimler shares, 1.68% in shares of Infineon Technologies and so on, until he has all 30 stocks that make up the index in his portfolio.
If the DAX index climbs, which means that the prices of the shares that compose the index are rising, the manager can be sure that the value of the fund’s portfolio will grow in the same proportion. (The fund’s performance will always be slightly lower than that of the index due to costs related to the purchase and custody of securities and administrative costs of the fund.)
What does this mean in practice?
For the fund manager: a more peaceful life. Since the composition of a stock index is publicly known, it is sufficient to stick to it carefully when investing to achieve a performance close to that of the index. At the same time he can do without any sophisticated and above all expensive research and analysis. On the other hand, the fund’s performance will never be better than the market index.
For investors: significantly lower costs. As a passively managed fund has no research to finance, its operating costs – which are always charged to the investor via different types of commissions – are very low compared to actively managed funds. Thus, subscription fees charged to investors for the purchase of passive funds often represent only a fraction of those charged by active funds.
Regarding the fund’s performance, we have seen that if follows that of the replicated index. If the index rises, the fund’s value also rises, but never more than the index. However, if the index is falling – a sign of a declining market – the value of the fund also decreases, and it will decrease just as sharply as the index.
Thus a passively managed fund does not provide the opportunity to achieve a performance that is better than the market index, but it does not bear the risk that its performance will be significantly poorer than the index either.
Passive funds are often traded at the stock exchange – these are the famous Exchange Traded Funds or ETFs – so that investors can buy or sale these funds at any time.
* as at 27 May 2016