Good and Bad Aspects of Passive Funds

Investing via exchange traded funds (ETFs) and other forms of index-tracking management can make sense, as it minimizes costs and avoids manager selection risk.

The trouble with its alternative, active management, is finding those who are consistently good at it, without most or even all of the gains being gobbled up by fees and other costs. Usually such managers are too frightened of the risk to their careers in making idiosyncratic decisions to stray far from being almost-trackers. They are poor value for investors.

The trouble with passive management is, it means putting your money into the most popular shares, which are the most expensive because of their popularity, and may be the poorest choices for the longer term.

As Ian Lance of RWC Partners reminds us: “Passive investors in 2000 were allocating large chunks of their money to bubble stocks like Cisco, Sun and Yahoo, and also to accounting frauds like Enron and Worldcom, which were on their way to zero.”

The bias towards buying the biggest stocks, which are not likely to be the best, seems to be particularly true in the emerging markets sector.

Well-known fund manager Terry Smith says increasing amounts are being allocated to its largest companies, but “they are not good companies.”

Last year the return on capital employed of the top ten constituent stocks of the MSCI Emerging Markets index averaged just 12 per cent. Over the past ten years their returns have shown a more or less continuous decline. That has been particularly true of Chinese companies, “which seem to be investing on the basis that debt capital… for them is close to free.” Such an assumption is always dangerous, “as the Dotcom era and Japan in the late 1980s illustrated.”

These giant companies are expensive, currently trading on price/earnings ratios averaging 28 times, compared to 23 for all firms in the MSCI index. It doesn‟t seem likely that this reflects expectations of significant improvement in earnings.

Trouble is, “if money pours into markets via ETFs, it will cause the shares of the largest companies… to perform well irrespective of their quality or value, or lack of it, even though active managers seeking quality and/or value will not want to own them.

“The weight of money flows will make it a self-fulfilling prophesy that the index will outperform the active managers who behave in this rational manner.”

Longer-term, it makes sense to buy more shares in good companies. They will eventually produce superior returns. But you need patience to wait for that to happen. In the meantime, the weight of index-tracking buying makes it difficult to manage actively, focusing on good companies that are not popular. That‟s why most investors would do better to opt for index funds such as ETFs.

A courageous admission by an expert who himself manages an emerging markets fund.

David Fuller's view

I have long favoured Investment Trusts also known as Closed-End Funds in some other countries, including the USA. 

Incidentally, Iain Little includes a review of Investment Trusts during each of his Markets Now presentations, the next of which will be on Monday 12 June at London’s Caledonian Club.   

Here is a PDF of On Target.