BENCHMARKING AND THE RISE OF INDEX TRACKING FUNDS

Index trackers have long been a favoured solution by regulators, and many IFAs also subscribe to the view that the minority of fund managers who do out perform the index are rarely the same ones, and that risks are better balanced out by investing in passives.   

But what is the long term affect of this?  After all if every fund was an index tracker, and only one single active manager survived, that active manager could be a half-wit and still relatively easily beat the index by predicting which firms are joining and leaving the treasured index, as mergers and break ups are announced they would invest based on the certain knowledge that index trackers would be forced buyers or sellers. 

It also has an affect on the listed companies themselves.  The “Index Inclusion Subsidy” is a topic for many student theses and was articulated in this almost unreadable mathematical research paper HERE , which claims to prove the same point mathematically.  The  maths is beyond me, but the summary builds on the well known fact that most acquisitions by public companies do not add value. 

Listed companies that are part of a giant ETF index tracking portfolio are guaranteed ongoing flows of capital from passive investors.  These automatons only put money in because that company is included in the index.  For the public company itself, the share price becomes driven by passive forces, and less by the terrible decisions of their directors and the CEOs may as well cast aside pessimism and go on the acquisition trail.  It will not downgrade their share price, and if they get bigger they might just be able to apply to join a bigger and better index!  Forget value, go index!   

The FCA would, I suspect, have us all put our customers into trackers, because they have consistently cast doubt on the ability of managers to out perform the index.  Admirable cynicism, but this article shows that there is life yet in the old dog of active management.  If we all went to tracking, a new scandal would surely emerge, of listed companies abusing the share price support of their CEO’s mad capers in search of bigger and better.