Regular visitors to The Value Perspective will know it does not take much to have us restating our misgivings about the way some investors are inclined to use market indices – and a new report from PwC suggesting the amount of assets held globally in exchange-traded funds (ETFs) will exceed $7 trillion (£5.4 trillion) within the next five years is way more encouragement than we need.
ETFs: A roadmap to growth predicts new markets and expanding distribution channels and asset classes will see the North American ETF market grow 23% a year to reach $5.9 trillion by 2021. The report also expects the European market will grow 27% a year in this time to reach $1.6 trillion while Asian firms expect ETF assets under management to reach $560bn – an 18% annual growth rate.
And this all could happen. Our equally oft-stated misgivings about the accuracy of predictions aside, we are not having a go at the report – or indeed at market indices in themselves. As we have argued in pieces such as Market farces, however, while indices can make perfectly acceptable targets for investors to try and beat on a three or five-year view, they are a terrible way of gauging risk.
In a recent note, The tyranny of indices, Cha-Am Advisors offers no fewer than eight reasons as to why this is so – ranging from dividend distortions to the fact that, while related, the index is not the market. One argument that particular caught our eye was how, as they are forever being tweaked by their compiler, any index used as a benchmark in fact represents a set of constantly moving goalposts.
“Over time, the shares of companies, sectors and indeed countries that are doing less well are ejected from the index and replaced by shares doing better,” the note points out. Compare, for example, the constituents of leading US index the Dow Jones Industrial Average today and those when it launched and you will find only one name common to both lists – General Electric.
Cha-Am likens this to the sword of William Wallace on display in the National Wallace Monument in Stirling, which is reputed to have had three new blades and two new handles. And if that reminds you of anything, it could be Plutarch’s ‘Ship of Theseus’ – or indeed Trigger’s broom or the Sugababes pop group – all of which ever-regenerating phenomena we referenced in Only fools and bourses.
Whatever the reasons PwC puts forward for anticipating such buoyant future ETF growth, there seems little doubt a significant reason for the sector’s giant strides in the recent past has been the loud and constant refrain of many commentators that investors should unhesitatingly head for passive funds on the basis the average active manager never beats their benchmark index.
Yet, as the Cha-Am note points out: “Given that ‘the index’ has no trading, compliance or research costs – and no liquidity restraints – it is actually not that easy a target for active fund managers, who bear all of these burdens, to beat consistently. It is a near statistical inevitability that over time ‘average’ active managers will underperform their relative benchmark index.”
But, of course, the average passive fund also has costs of its own to meet – albeit to a lesser degree – and so it too will fail to beat its benchmark index. Furthermore, passive or index-tracking funds are the dictionary definition of ‘dumb money’. They undertake no research. They do not care about the quality of a business or its management team or whether or not it has debt or whether or not it is cheap.
Passive funds simply buy stocks that are large – and growing larger – and sell those that are growing smaller. It is for this reason, for example, that trackers – without any thought for the risks they were taking – allocated a third of their assets to the most overvalued sectors such as technology, media and telecoms in 1999 … just before those sectors fell on average by 45%.
Finally – and this point is often overlooked in any discussion of the merits of active and passive funds – while there is absolutely no chance of a passive fund outperforming its index, a substantial minority of active managers will do so over time.
The trick – and it is no mean one – is to identify such managers in advance. The one approach we would suggest is to identify those who follow a durable, rigorous and repeatable investment process such as the principles of value – a strategy that has continued to reward its long-term adherents, regardless of the massive changes in markets (and their indices) witnessed over more than 100 years.