commentary

authored by

John Kierans
May 2020

The Problem with Index Funds

The total number of companies listed on stock markets globally is around 43,000.  According to the Index Industry Association (www.indexindustry.org) there are 3 million equity funds in the world.  That is 70 times as many funds for stocks as there are stocks themselves.  I found this statistic staggering and hard to comprehend at first.  But think of it this way – each EFT, UCIT, or Index is nothing more than a combination of stocks.  Wikipedia tells us that there are almost 14 million different 6 digit combinations in a 49 digit lottery game (1 – 49).  So perhaps 3 million combinations (funds) drawn from a total pool of 43,000 stocks is not so extreme.  

The combinations or buckets of stocks are often categorized by geographical area or country specific, by industry or sector within an industry, large cap, mid cap or small cap, growth or value, new or old, high risk or low risk and on and on.  All of this choice and competition should be a good thing for investors, although it might be a little overwhelming!

Of the three million equity funds available today, passive funds are proving to be the most popular.  The chart below illustrates the growing popularity of passive investments.  As of January 2020 they surpassed actively managed funds.

In 1976 one of the founding fathers of passive investing Jack Bogle launched his Vanguard 500 fund.  The fund offers investors exposure to all of the S&P 500 shares. Simply put the fund buys and holds the shares that make up the stock index.  For this it charges minimum annual fees and zero performance fees.  Below is a 20 year chart of the index’s performance including reinvested dividends (2000 – 2020).

After 2 crashes in the first 10 years it finally achieved a new high in April 2013 and has more than doubled since.  Passive products offer investors real choice and provide stiff competition to active managers, particularly those ‘closet passive investments’ masquerading as active investments.  I picked up the term ‘closet’ from a BIS (Bank for International Settlements) report.  Closet indexing, as it is also known, is a ruse where an ‘actively’ managed fund that seeks to outperform a benchmark index is in fact doing little other than tracking it.  For example the ‘ABC’ stock fund that benchmarks itself to the S&P 500 may buy 450 of the ‘best’ 500 stocks listed and hope for an out performance.  Win, lose or draw the promoter gets to charge active management fees.

Is Passive Investing a Winning Strategy?

Passive investment products have one stand out feature – they are cheap. This is what makes them effective.  In the long term markets produce winners and losers.  Reducing your investment fees does not solve the problem of whether you will be a winner or loser.  The Vanguard 500 fund guarantees that you are a winner in a rising market.  Equally it guarantees that you are a loser in a crash.  Passive investing is not a winning or losing strategy.  In point of fact it is not even a strategy.  It is just a product.

A Changing Industry

Since 2017 there has been a 7 fold increase in the number of equity funds in the market.  The investment banking industry has undergone huge change in the last 20 years, brought on by technology and steered by regulation.  Traditional investment banks are being surpassed by specialist players like Vanguard, State Street and Blackrock.  In order to compete, the investment banking industry has at least in part evolved into a fund creation, management and distribution industry.

This move towards a ‘distribution’ model coincided with a move away from individual stock analysis. In the latest annual survey from the financial communications consultancy, Citigate, Dewe Rogerson suggests a drop off in research. Surveying almost 250 investor relations officers from leading companies across Europe, its findings point to a decline in both the quantity and quality of analyst coverage since the most recent barrage of regulations was implemented (MiFID II) in January 2018. Half of UK-listed companies (52%) reported a year-on-year drop in the number of analysts covering them.  40% of European companies reported a drop in analyst coverage.

Aside from occasional surveys it is hard to quantify the drop off in stock analysis.  All we can say is that there is some anecdotal evidence.  Check out the chart below from the FT.  

So what does it all mean?

The Bank for International Settlements (BIS) is concerned about the quality of stock specific price information. The UK’s Financial Conduct Authority has expressed concerns about lower standards of corporate governance due to less individual stock analysis.  Even Jack Bogle (RIP) worried that passive investing may become a victim of its own success.

I disagree with the BIS, FCA and even Jack Bogle himself insofar as they have failed to identify the big problem – lack of diversity.  The industry is offering investors 3 million ways to do the same thing – buy the market.   It is not offering enough in the way of risk management or downside protection.  Theirs is mostly an ‘everybody buys and everybody wins’ mantra.

Unfortunately you cannot socialize winning.

return to commentaries