Index trackers are like the curates egg

Some investment “experts” will tell you that there’s no point paying a fund manager to manage your money.

You don’t need them to pick the shares, or sectors or countries to invest in, they say,

All you need to do is buy the whole world stock market with some index tracking funds.

So… are they right?

Well, there can be benefits in using ultra low-cost index-tracking funds within your investment portfolio – but investment decisions are not quite that simple.

By the way:

Index tracking (aka “passive investing”) is where you don’t pay a fund manager to move the shares around in your funds.  The index tracker fund simply (passively) follows the stock-market index that it’s tracking. So your money is exposed to both ups and downs in the various shares in an index – in the same proportion as those shares make up the index.

In a nutshell . . . this means that a stock-market index tracking fund will not answer all your investing challenges throughout your life.

These funds do not mix stock market investment with other, lower risk investments (like cash deposits or fixed interest investments) so, you might still need some help with that.

What we know for sure (and as anyone invested only in stock market index-tracking funds during market crashes can tell you) is that  . . .

Index trackers do not protect you from market ‘timing’ risk

Sure, you might save a couple of tenths of one per cent on fund charges. But that won’t be your main concern if you find yourself in a fund that drops by 50% in value over the coming years!

And that’s what Index Trackers do – from time to time. They follow the market . . . down as well as up 😉

Now, the risk here is not just about whether the market as a whole is overpriced. It’s about the extent to which certain sectors or shares are overpriced.

What do I mean by that?

Well, anyone who bought an allegedly well-diversified worldwide index-tracking fund in 1989 would have picked up a belly full of Japanese shares.

And that would have been very painful because that index then fell by 75% over the next 23 years – as we saw here.

Similarly, anyone who bought a FTSE 100 or S&P 500 index tracker, in the late 1990s will know the problem with these funds.

As Merryn Somerset Webb in the Financial Times put it, they were ‘effectively forced to buy big stakes in obscenely overvalued companies, with no history of profits or even sales, as their prices rose’, and worse still, they ‘ended up under-exposed to stocks with long and proud histories of earnings and dividend growth.’

That was the ‘dot com’ bubble in technology stocks

The Japanese stock market and the worldwide technology bubbles are just two examples of what the textbooks call a ‘capitalisation weighting’ problem with traditional trackers.

What?

Sorry, in plain English, this means that these ‘tracking’ funds are obliged to hold lots of the stuff that’s already gone up a lot in price.

You see, once the price of a share has risen significantly, it makes up more of the index. And as these funds track the index so they must hold more of it too.

Conversely, the trackers are forced to let their holdings shrink in those shares that have fallen out of favour and, perhaps, become undervalued.

And when a share falls in value so far that it falls out of the index altogether, an index-tracking fund will have to sell it in order to continue replicating the index.

So, index trackers are NOT cleverly managed funds.

They’re run by computers that simply copy the index and that’s why they’re cheap.

Okay, but what about actively (intelligently) managed funds?

Well, truly actively managed funds are quite rare.

And that’s because quite a lot of active fund managers simply hold (broadly) the same types of shares as are in the index.

What?

Yes, they do this because their performance is often measured against the index. So, they don’t want to risk being too far away from it!

These (not very) active funds are what we might call ‘closet index trackers’  because that’s what they really do.

The trouble is that they charge more than a computer to do it. So, whilst they (broadly) follow the index, they’re certain to underperform it due to their costs!

Interestingly, this problem finally caught the attention of our regulator – the Financial Conduct Authority (FCA) a while back and they produced a nice paper on the matter after 18 months of investigations.

Whether their proposed remedies will change much, I’m not sure.

I’m not aware that they’re going to impose price controls on “closet trackers” (actively managed funds that are not actively managed) because to do that would mean you’d have to define a “closet’ tracker”

You’d need to say by how much and how often (over what time period) a fund’s holding would need to differ from an index – for it not to be classed as a closet tracker. And I really can’t see that happening.

So, I think this problem of overcharging for closet trackers will continue …

… and you need to to be aware of it to protect yourself.

You need to understand the types of fund you’re buying and how much you’re paying for them.

And, if your financial adviser gets ‘involved’ in the fund management aspects of your money (which is not always a good idea!) then you need to factor in their fund management costs in your overall assessment. And that can add up to a lot.

So, are low-cost index-tracking funds the answer?

Well, their devotees will tell you that they are.

And they’ll point to studies showing that 70-80% of all active fund managers fail to beat their index over time.

And yes, these claims are true. Indeed, they’re not really surprising when you consider all the ‘closet trackers’ that are classed as actively managed funds.

However, it’s also true that around 98% of footballers across Europe are not good enough to play in the premier league. But that does not mean that there are no great footballers.

You just have to be careful about picking your fund manager and yes, I’d tend to pick several just in case the one you pick breaks a leg at a critical time!

The bottom lines

The vast majority of funds – including 100% of index trackers – fail to beat the index over the long term.

That’s because they only aim to match it. They copy (or closet copy) everything in the index. So, they can’t beat it once they’ve taken their charges (for administration and trading) from the fund .

A lot of good tracking funds get close to their index but none should beat it. It’s not their objective to do so – and any tracker that does – is not being managed properly!

If you’re happy with the index return for the stock market bit of your investments then you could buy a good quality, low-cost tracker fund.

Do not pay the additional charges of an active fund manager to ‘closet track’ an Index.

However, if you need an intelligently mixed portfolio – of higher risk / hopefully higher return elements (like shares) plus lower risk/ certainly lower return elements (like bonds and cash) – then you may need someone to create that for you.

And if you do, then look closely at how your prospective fund manager’s funds have performed over various time periods in the past.

Look at their performance during times when markets have been in free fall because those are the times that could keep you awake at night in the future.

The thing is that any idiot can produce good results when markets are booming – frankly, it’s difficult not to. But if you want a fund manager who’s concerned about protecting against downsides as well as making money on the booms you need to pick one.

Good active fund managers investigate a range of factors about the securities they hold in their funds  – whether its shares or bonds.

With regards to companies whose shares they hold in their funds . . . they will look at the quality of the management team of those companies, their current and past profits, cash flow, debt levels and dividend payments etc. And, critically they’ll consider the prospects on these measures for the future.

A tracker fund does none of this – it just buys everything in the index.

So, whilst index-tracking funds can be okay – as a core holding when markets are fairly valued – they’re not a wonder investment fund in all market conditions.

And at certain times, trackers can become very risky funds indeed.

The rush into trackers may have made markets MORE risky

This idea, as pointed out by acclaimed fund manager Bob Rodriquez here is an important one.

His argument is that the rush into index trackers of the past few years may even be creating ‘perfect storm’ conditions in stock markets.

Rodriquez points out that passive investing has risen from c.8% of funds to almost 40% today. That’s a big shift.

And given that most index funds are capital weighted  – it means more and more money going into fewer and fewer stocks. (The capitalisation weighting problem mentioned above)

‘We’ve seen this act before’, says Rodriquez.

‘With the nifty 50 stocks in the early 1970s and the dot com stocks in the late 1990s.

‘If you were a growth stock manager in 1998-1999 and you were not buying “net” stocks, you underperformed and were fired.’

‘Today we have a similar case with the FANG stocks (Facebook, Amazon, Netflix and Google) whereby more and more money is being put into a narrower and narrower area.’

‘In the previous cases, this trend did not end well’

‘When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button.’

‘All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.’

‘We are witnessing the development of a perfect storm’

What about fund management costs?

Well, it’s often argued that index-tracking funds are significantly cheaper than actively managed funds.

And, as I’ve said, if your actively managed fund is simply a ‘closet’ index tracker, then you are indeed, wasting your money on higher charges.

However, if you buy high quality actively managed funds – the additional costs are really not that great when you add it all up.

The key thing you need to do – is to compare fund management costs on a like-for-like basis.

And be sure to add in any ongoing adviser charges (for fund management) if your adviser manages index trackers for you.

Once you do that you’ll often find that good quality actively managed funds cost about the same as index-tracking funds with active management from an adviser. Possibly even less.

Final thoughts

What bewilders me about the Index tracker fund fanatics is the inconsistency of their actions.

You see, they understand the need to re-balance the overall ‘mix’ of assets in a portfolio – between (shares, bonds and, property etc) to control risk.

And yet, they don’t seem to see any need for re-balancing the stock market part of it!

For many, this is due to their belief in the ‘price is right’ idea of efficient markets. They’re reluctant to ease you out of certain stocks or sectors because they believe that all stocks and sectors are correctly valued at all times.

But let’s be quite clear about risk.

If you stick with an index tracker as the price of shares in certain countries or sectors ramp up into a boom (like dot-com companies in the late 1990s or Japanese stocks in the late 1980s) you will end up with a riskier fund than a good defensive and actively managed fund. The latter will tone down your exposure to those stocks at those times.

So, take good care out there  – and if you have capital invested, remember that market timing and portfolio construction really does matter.

And if you’re in or moving towards retirement it matters a whole lot more – as we saw here

So, please take extra special care out there right now

And thanks for dropping in

Paul

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