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Passive Investing Continues Its Rise: How Trackers Continue to Reshape Financial Markets

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By mid-December Morningstar data indicated that over the course of the year £7.8 billion of capital had flown into UK-based passive tracker funds. Over the same period £7.9 was taken out of actively managed funds. And it’s not a UK-specific anomaly but a trend that is well and truly global and has been developing over several years now. Nor is it a trend that is more prevalent among retail investors that lack the experience and knowledge to build a portfolio from individual stock picks. Institutional investors such as pension funds are also allocating more and more capital to passive trackers.

Tracker funds do what they say on the tin and simply track an index. It could be a benchmark index such as the FTSE 100, 250 or All-Share, or the S&P 500 and Nikkei 250. It could be an index tracking a region, such as Asia Pacific or a broad asset class such as emerging markets. Or it could be a sector index such as technology stocks, biotech or house builders. And they might be global, regional or local. But whatever index is being tracked, that is all a passive tracker fund does – track it. So if the FTSE 100 gains 5% or loses 5% over a year, so will a FTSE 100 tracker fund. Or so close to the actual index any tiny variation will be entirely insignificant.

Passive tracker funds are particularly suited to retail investors. Firstly, minus the fees charged by active fund managers that pick and manage a portfolio comprised of individual stocks, or even a curated collection of tracker funds, they are much cheaper. Even while active funds have slashed their average fees by up to 30% over the last few years to remain competitive, passive funds already small fees have been cut further. The most expensive tracker funds charge an annual fee that is usually below 0.5% while the cheapest can go below 0.05%. The average fees charged by actively managed UK-listed or based funds are around 0.75%. The cheapest options will still be at least 0.5% and the most expensive up to 2%.

The problem for active funds is that while investors would be happy to pay the extra layer of costs for better returns, fund managers are proving unable to deliver them. Warren Buffet is widely considered to be one of the best, if not the best, stock picker in the world. But even his advice to investors has, over the last decade or longer, been to invest in a tracker fund. 10 years ago he made a bet with Wall Street investment firm Protégé Partners that a cheap tracker fund that mirrored the overall performance of the U.S. stock market would outperform the average return of a hand-picked group of over 200 elite hedge funds over a decade.

That decade concludes at the end of 2018 and the results are in. Buffet’s cheap-as-chips tracker has returned 126% over the period and the elite hedge funds an average of 36%. That’s an average annual return of 12.6% to 3.6%. The fund managers behind the latter are paid handsomely and would have bought and sold hundreds of stocks over the period in their attempt to beat the market. Teams of analysts would have contributed to informing the investment decisions taken. And the result was more than 3 times poorer.

Tracker funds also come in different formats. ETFs, exchange traded funds, are bought and sold in units and, like stocks, can be transacted throughout the day. Others are structured like mutual funds. Passive tracker funds first appeared in the 1970s but it is over the decade since the international financial crisis that they have soared in popularity. And the amount of money now invested in tracker funds, around $10 trillion globally at the last count compared to under $2 trillion in 2008, is starting to have a major influence on financial markets. To put that $10 trillion into context, the entirety of the capital under the control of the hedge fund and private equity sectors is less than a combined $5 trillion.

For the average retail investor, the logic behind investing in a tracker fund is the logical truism that the market is made up of investors so it is impossible for the average investor to beat the market. For every investor whose returns beat the market there has to be another whose losses even that out. While it is human nature for fund managers to have the self-confidence they will end up on the winning side of that mathematical truth but the reality is a high majority of them don’t. The data-based evidence shows very few professional fund managers consistently beat the market over an extended period of time. So it just makes sense to save the headache and opt for a tracker fund.

Critics say the tracker funds are making markets less efficient as they allocate capital blindly by simple virtue of an asset being part of an index and with no regard to its fundamentals. Paul Singer, one of the most famously successful head fund managers in history has accused passive trackers of ‘devouring capitalism’. The crux of the argument is that by virtue of being part of an index such as the FTSE 100 or S&P 500 that has huge sums of tracker fund capital invested in it, there is demand for the company’s stock, putting a floor under its price. So even if the company is not doing particularly well, it is ever more difficult for a better performing company in the FTSE 250 to swap places with it.

It’s not an argument without merit as the influence of tracker fund capital grows. If all capital, or just a significant majority of it, is in tracker funds then what would drive markets? How will smaller companies be able to get bigger by demand for their stock growing because they are doing well, driving up their value? We would no longer have companies whose value drops with demand for their stock as their performance shows signs of deterioration if all investment was ‘blind’ tracker investment. Tracker funds also stand accused of fuelling investment ‘bubbles’ and posing a risk to deeper stock market crashes if capital were to be withdrawn from them en masse during a future market downturn.

Advocates of tracker funds counter that within the full scope of international financial markets, passive investing is still a small-ish player and does not have more than an influence on the demand for a company’s stock. If a company is not able to convince investors that it is doing well, it will still quickly drop in value. Even founding fathers of passive investment such as Vanguard’s John ‘Jack’ Bogle recognise that if passive investment continued to grow to the point passive funds have a commanding vote in most companies that would be a problem.

He championed index trackers as the best solution for the everyday retail investor and still believes that within that context they are the best investment choice. But he is not blind to side effects as the investment vehicle he did more than most to set on its current track, commenting:
 

“It’s hard to know how big we can get, and the consequences. But it does raise issues that we need to address. We cannot ignore them. But to solve this we should not destroy the greatest invention in the history of finance.”

Practically speaking, passive funds are still a long way from wielding the influence that would make them a real danger to the natural efficiency of financial markets, from equities to commodities and bonds. But as their popularity, and the value of funds under their control does grow, it is important to be aware of the risks. In the meanwhile, tracker funds are the perfect long-term investment vehicle for retail investors. And even for those who still wish to test their mettle as a stock picker or in other investment classes, they make for a solid foundation that can be augmented with more adventurous, riskier investments.




Risk Warning:

Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.

There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

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