Can a passive ETF really outperform the market?

James McManus


2 min read

Passive investment strategies, including exchange-traded funds (ETFs), typically aim to replicate the performance of a given benchmark (or set of assets). However, in some cases, passive ETFs may outperform the markets they track.

In the majority of cases, the passive ETF will aim to provide the return of the index, less any fees paid to the investment manager. Thus, to many investors the maximum return that can be achieved through passive investing is the market return (minus any fees).

However, what if it were possible for a manager to seek the same objective, but perform better than the given market or assets it is seeking to replicate? Can a passive ETF investment really outperform the market? And could it do so even after the fees paid for investment management?

The surprising answer is yes, in some markets, this is entirely possible.

While the drivers behind this can vary from market to market, the US stock market provides an interesting example for UK investors.

Our major holding in the US stock market is the Vanguard S&P 500 UCITs ETF, which seeks to track the performance of the S&P 500 index, comprised of the stocks of large US companies.

The fund currently charges 0.07% in management fees, meaning that in a perfect world an investor should expect to receive the return of the S&P 500 index, minus 0.07% paid to the investment manager each year.

However, when we look at the performance between 18/07/2015 (close) and 19/07/2016 (close), after fees have been paid, we notice something interesting:

Vanguard UCITS

The Vanguard S&P 500 UCITS ETF has outperformed the S&P 500 index by 0.28%, net of fees. This means our clients were, in effect, being paid 0.28% a year above the index return over that period.

So how does this happen?

The simple answer is that the fund, through virtue of its Irish domicile, is able to pay a lower rate of withholding tax on the dividends it receives from companies than the index assumes it can. This is because a tax treaty exists between Ireland and the USA, meaning withholding tax is applied at a rate of 15% to dividends, rather than the standard rate of 30%. So investors in this Irish-based ETF benefit versus those investors in funds based elsewhere (such as the UK, Luxembourg or even directly in the US itself).

Research, research, research

At Nutmeg, we dedicate significant resources to research on exchange traded funds. As our primary and preferred tool to implement our investment team’s ideas in client portfolios, we spend just as much time analysing the ‘nuts and bolts’ of individual investments we make, as we do conceiving the theory behind it.

ETF’s can often be considered a ‘simple, passive’ investment, where only the fee paid separates the funds available, but the reality is far more complex than many investors imagine. Dedicating resources to in-depth research in this way, is just one example of how we’re able to uncover performance advantages for our clients.

We’re passionate advocates of the passive ETF market, and self-confessed ETF geeks! Maybe that’s why our work has been recognised by the industry’s leading independent voice, ETF.com, who voted Nutmeg Best ETF Adviser and Best Robo Adviser (2015), and Best ETF Investor (2014) at their annual European awards.

Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.

 

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James McManus

James McManus

A self-confessed ETF geek, James is head of ETF research at Nutmeg. He joined in 2015 from Coutts & Co, where he was an associate director in the investment office. James holds a Bsc (Hons) in International Business from Nottingham Business School.


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