Passive funds, like sausages, are only as good as their ingredients



Ian Kelly
Fund Manager, Equity Value

When you think about what can go into a sausage, it may leave you feeling a bit queasy – and investors would probably feel the same way if they stopped to consider what makes up the bulk of some tracker funds


We understand the logic of investing in exchange-traded funds (ETFs) if you just want to buy into a certain market. Some of our clients also read good things about so-called ‘smart beta’ ETFs – which try to extend the concept of simple index-tracking products by focusing in on a specific investment style.

Obviously they know we are keen advocates of the value investment style – and so we are starting to hear the question: “Should we buy a value ETF?” We reply with the analogy of the sausage machine.

To be clear, we are not having a pop here at the humble banger, which is frequently delicious. No – all we are suggesting is that, once you stop to think about what can often go into one end of a sausage machine, you may be inclined to think twice about ordering what comes out the other the next time you fancy a Full English.

ETFs are only as good as their ingredients

Our point of course is that, like sausages, ETFs are only as good as their ingredients. So, when a client suggests buying a value ETF, we ask them what they think goes into one. At this point, things can go quiet. Eventually we may hear an uncertain “Cheap stocks?” – even if no-one seems too willing to express this in concrete terms. Our conclusion is that some investors may have been sold on the concept, but they do not really know what they are consuming…

Over the coming weeks, we will consider this idea from a number of angles but, today, let’s look at it from the point of view of an index provider.

Index providers

Stockmarket indices are used as a way of encapsulating a particular market – for example, the FTSE 100 in the UK or the international MSCI World. They are also used as a way to compare the performance of investments. The first thing to understand here, however, is the principal clients of the companies that create these indices are not end-investors.

The principal clients of index providers are the fund management companies that seek to replicate or beat the indices with their own products. As such, one of the main considerations of the providers is to create indices that are straightforward to replicate and inexpensive to trade. And the easiest and most practical way to do so is by ‘weight’ – that is, by reference to the size or ‘market capitalisation’ of the constituent companies.        

That way, as the companies’ share prices move on a daily basis, the index providers’ clients do not have to constantly rebalance their portfolios or – heaven forbid – take any active decisions. If an index is not market capitalisation-weighted and the ETF that is tracking it is committed to following a rule, then it will have to do a huge amount of trading. That is expensive – but ETFs have to follow their rules.

The second thing to understand is that capitalisation-weighting of an ETF allows it to grow very large – as in billions of dollars. This is because the largest weights in the ETF are in the largest companies, which are generally those that have the most shares available to trade. So, capitalisation-weighted ETFs can grow very large, which generates nice fees for the ETF provider and enables them to pay larger fees to the index provider.

None of this is really seeking to blame the index providers or the ETF companies. They are just doing what they do – the latter follow what the former offer. It is just that the index providers now have an incentive to build indices that are easy to replicate rather than ones that necessarily produce good returns. And, in doing so, they are serving to create the investment equivalent of the sausage machine. Or sausage machines.

An example of a 'value ETF'

Let’s take just one, however – the MSCI World Value ETF which, as its name suggests, looks to offer a value slant to an otherwise passive portfolio of international companies. For now, we will set aside the question of how index providers judge whether a company is ‘value’ or ‘growth’. Today we are thinking about once that judgement is made and the value ‘mincemeat’ is waiting to go into the machine. How do you think the different proportions are decided? How much of each value stock goes into your value ETF?

The principal determinant of the weight any company is attributed in this index is not how ‘value’ it is – not, for example, that it has an attractive valuation metric such as a low price-to-book or price/earnings ratio – but how big it is. How many investors in ETFs that replicate the MSCI World Value index realise the biggest factor they are exposing themselves to is not value but size?

And yet, as the following chart illustrates, almost one-third of the companies that make up that index have a market capitalisation of more than $130bn (£105bn). They are, in other words, some of the largest companies in the world.


MSCI World Value ETF, market cap vs weight


 Source: Bloomberg, December 2016

At the same time, a good chunk of the ‘smaller companies’ (in the bottom left corner) are still $50bn in size – and even then, at about a 0.3% weight each, they will have no material influence on performance. So the biggest positions are the biggest positions not because they are super-cheap, but because they allow the index providers to build an industrial-sized value sausage. It is not an appetising thought.

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Ian Kelly
Fund Manager, Equity Value


The Value Perspective
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