due diligence

Due Diligence on Passive Strategies – Not to Be Taken Lightly!

Why doing a thorough due diligence on passives is as important as on actives, and which are key areas of due diligence for passive fund selection?

In 2019 market share for passively managed funds reached 45% of all assets in the US stock-based funds, according to Bank of America Merrill Lynch.

Based on Morningstar’s report, at the end of September, passive funds even surpassed active funds in the total value of managed assets. Passively managed funds (both ETFs and mutual funds) reached about $4.37 billion in assets under management, compared to active funds with about $4.27 billion worth assets.

Indexing – a strategy with both positive and negative sides

Growth of passive strategies and index investments can be explained by low costs, broad diversification, and tax efficiency, as the main advantages.

But this strategy can have its negative sides as well. One of them is focusing too much on simple geographic asset allocation and thus missing real drivers of outperformance. A simple approach of buying the index as cheaply as possible has worked pretty well in recent years, but it might not be the case in the future. With volatile trends on the global market, a precipitant and prolonged market change could cause passive products to underperform, resulting in liquidity issues.

Why is due diligence on passives as important as on actives?

So how can an asset owner interested in investing in passive strategies best prevent his investment? The answer seems to be simple – by choosing the right index and the lowest fees. However, the experience shows that it’s easier said than done.

As with active funds, research done on passives should take into consideration both quantitative and qualitative details.

Qualitative due diligence is important to assess the managers’ capabilities to implement their passive strategy effectively on a forward-looking basis, by focusing on the business, team, and investment process.

Not all passive strategies are created equally, and not all passively managed funds operate under the same management principles.

Key areas of due diligence for passive fund selection

Here are some key areas due diligence for passive fund selection should address in order to extract the best matching passively managed fund.

  • Costs structuring

Passive funds’ total cost of ownership consists of the annual manager’s cost of managing the fund (known as Annual Management Charge), additional costs, which include different fees, such as administration, audit, or custody fees, and operational expenses. When performing the due diligence on passive strategies, it is essential to ask about the cost structuring in total, because managers sometimes quote only Annual Management Charge (AMC).

When talking about the costs structuring, there is one more area into which it is wise to take a close look – entry and exit charges and pre-set dilution levy. Depending on how they are set, these charges can benefit a client, or mean extra costs.

  • Tracking error and excess return

Looking into a fund’s tracking error and excess return shows how successfully a fund tracks its index. Thorough due diligence on passives considers both measures, as they gauge discrepancy between dealing and trading fees at passive strategies.

Insight into excess return gives an accurate overview of a fund’s performance compared with its benchmark over a defined period. All these measures, examined together, help to evaluate a fund’s performance.

However, differences in tracking methodologies and the methods to calculate performance can make comparisons difficult.

  • Replication

A fund manager can track indices physically or synthetically (using derivatives). Understanding how indexes are replicated is an important component of due diligence for passive strategies.

  • Securities

One of the components of due diligence on passive strategies is an examination of how the manager deals with securities and how a fund’s policy on reinvesting collateral is set, or in other words – who benefits from the additional returns. The question to which it is beneficial to know a definite answer is – does the manager keep a large part of lending profits for itself, or redistributes it into the fund where it can benefit its clients?

  • Risk management

Even though passive strategies are considered “less risky,” examining risk management in due diligence for passives shouldn’t be ignored. Just like with active strategies, areas to be tackled by due diligence are operational risk controls, information security, compliance procedures, and conflicts of interest.

  • Independent ratings

Independent ratings give an unbiased presentation of a passive investment manager relative performance, as well as of strengths and weaknesses, and general quality of the manager’s investment process. That’s why it is recommendable to examine this area in the due diligence process for passive strategies.

  • Experience and brand

The manager’s reputation may not be the most critical area of due diligence on passives. However, it still matters, as it reflects the manager’s experience, knowledge, and capabilities.

  • Focus and scale

Manager’s focus on passive is an important are of assessment. The size as well, as bigger firms can optimize costs easier.


Passive funds are structured, managed, and traded differently from active funds. However, products from various passive investment providers can differ significantly, just as those of active funds. Thus, the right choice of the high-quality and best suitable passive fund depends on the thorough due diligence – same as for active funds.


Dasseti is a web-based solution that digitizes your complete due diligence process. If you would like to know more about how we can help you customize your due diligence for passive strategies, please contact us.

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