Why does my index fund fail my due diligence screening?

Every once in a while the fi360 Tools team is asked the question, “Why does my index fund fail my due diligence screening?” The answer changes from fund to fund and is dependent upon the data and circumstances at the time. However, the common conception that index funds as passive investments are “set it and forget it” strategies is incorrect. They must be monitored along with all investments. Furthermore, don’t be surprised if the index fund you’ve selected earns a poor Fiduciary Score or lags its peers in performance.

To illustrate this point, we examined index funds in the fi360 Toolkits for the period ended September 30, 2009.  We identified index funds that fell below the median for both the Fiduciary Score QTR and AVG (see the fi360 Fiduciary Score Methodology Document for more information on our process), and index funds that fell below the median manager in their peer group for several return periods.   The results in the table below show that index funds can rank poorly against a comprehensive process like the Fiduciary Score or, for that matter, many performance periods.

	# of Peers	Index Funds below Median	% Below Median
Fi360 Fiduciary Score (QTR)	968	398	41.12%
Fi360 Fiduciary Score (AVG)	968	351	36.26%
1 Year Return	968	647	66.84%
3 Year Return	968	534	55.17%
5 Year Return	735	419	57.01%
10 Year Return	273	196	71.79%

The next important step in the monitoring process, especially for index funds, is to dig into the shortfalls.  For example, you may want to begin by comparing the index fund’s performance to its specific tracking index in addition to its assigned peer group.  Funds may be correctly tracking the stated index, but still fall below the median manager in their peer group.  This could occur because:

• The fund manager is tracking an index not followed by others in the peer group.
• The peer group chosen for a fund may not be appropriate.

Certainly, there are other qualitative analysis points that may need to be pursued when monitoring an index fund. The point being, the combination of both a core due diligence process and an evaluation of the fund’s tracking index will help identify any deficiencies of the index fund, and lead to improved decision-making related to watch vs. replace decisions.

These are our thoughts. How do you examine index funds in the course of your due diligence process? Let us know in the comments section below.

Comments

[Eric]

Index funds historically fall in the middle of the returns. When index funds are on the watch list it is a clear indication active management is outperforming passive management net of fees.