Happy 50th birthday, passive funds

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Happy 50th birthday, passive funds
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Make just one investment and you own the whole market – any investor's dream, right?

There is no doubting the influence of the passive investment phenomenon on modern equity markets. It is, after all, by far the easiest way to be diversified across the entire market.

The proof of the pudding is in the eating as they say, and with over $16tn (£11.83tn) in global index funds since John McQuown and his team at Wells Fargo set up the first ever ETF five decades ago, it is fair to say numerous investors have had their slice of an increasingly large cake.  

But as with any investment, and birthday cakes, one can have too much of a good thing.

In fact, has anyone considered that, for some investors, index investing may be one of those cakes with too much icing and sprinkles, and not enough sponge?

It is easy to forget that passive investing has removed price discovery from the equity markets.

There is a strong mainstream consensus that passive management will grow significantly as a share of global equity AUMs.

Models that push people into indices mimicking investment strategies do not require the security-level analysis that is required for true price discovery. Sound familiar? 

It should do, as this is similar the synthetic asset-backed collateralised debt obligations bubble of the late 2000s.

Price setting in mortgage-backed securities was not done by fundamental security level analysis, but by massive capital flows based on risk models that proved to be false. 

Index funds are so easy and effective that it seems every man and his dog owns shares in an FTSE 250 index because they believe it is good to hold a diversified basket of blue chip stocks that represent the market and hold them for a long time.

There is, of course, merit to this view.

However, it can also sound a lot like investors are not paying any attention to what they are actually buying.

While this works up to a point - as it is what passive investment is all about, apart from the cost argument - there are questions that have to be asked when investing in stocks just because they are in a certain index.

Think about it: “Why do you own shares in Virgin?” “Well, I don’t know, I just own an investment vehicle that tracks the FTSE and Virgin is in that index.”   

The point is that passive investing can remove price discovery from – in this case Virgin – which means there is some external force influencing the prices of the stock other than the underlying financial performance of the business.

That external influence is millions of investors all buying the index. This is exactly how bubbles form – when the underlying business performance is no longer the anchor for the true price of the stock.  

On the other hand, there is a strong mainstream consensus that passive management will grow significantly as a share of global equity AUMs.

Take a look at the 20 most valuable companies in the world by market cap today, compared to the top 20 in 1989. The top company at the time, Industrial Bank of Japan, had a market cap of over $100bn. The largest company in the world in terms of market cap today, Apple, has a value of $2tn.

It is hardly surprising that active managers have failed to outperform index funds over such a long period of time. Indeed, in stark contrast, active fund managers have never been under more pressure to deliver better returns to investors that they are today.

But this is not to say that passive index investing is the be all and end all, for all investors. For some, it will work well.

However, sometimes, for some, going against the consensus might be the right path to take. 

Tim Focas is head of capital markets for Aspectus