The alternative to active investing is passive investing. This process means that a fund simply buys every share in the index and that should guarantee it gets the returns of the index. Except that it doesn't. The problem is that you can't invest directly in an index so a fund has to be created to replicate it. The simplest way of doing that is to buy all the shares in the index in the same proportion. That incurs costs, although less than that of an active fund because it can be created mechanically without expensive input from analysts and the manager.
A more significant problem though is the logic that is used. A stock market index is based on the sum of the market capitalisation of its constituents. A company's market capitalisation is calculated by multiplying the share price of each company by the number of shares in issue. This means the index, and a company's weight in the index, is a reflection of the opinion of all the investors that are invested in it. There is no concrete link to any figure in the balance sheet, cash flow statement or profit and loss account for the company. It is simply the collective wisdom of the market about the company influenced by recent news flow and the views of analyst and investors about its future prospects.
As we all know opinions about the value of anything can vary enormously between individual and over time. In the recent past sentiment towards tech stocks, property shares and miners have all had their time in the spotlight. Anyone unfortunate enough to have invested in conventional passive trackers when one of these sectors were at the peak of their popularity would have discovered that their tracker fund would have had an unusually large exposure to whichever sector was occupying the most column inches in the press at the time.
A company's share price, and hence its market capitalisation, is partly a measure of how popular it is. This phenomenon was best explained by Ben Graham, that father of modern investing, when he said that in the short term the stock market is like a voting machine, in the long term it is like a weighing machine. It is because passive tracker funds are always overweight in popular sectors, and underweight in out of favour ones, that their performance always lags the index. Each time the index is recalculated the funds rebalance to the new weights and then spend the period until the next rebalancing suffering as popular stocks become unpopular and unpopular stocks return to favour. Passive trackers are essentially backward looking in that respect. Buying something at the same time as everyone else has never been the way to make money.
Think too about the logic of buying something purely on price with no inputs on quality or quantity. Few of us would go shopping intent simply on spending the most amount on the most expensive items. In real life if we see something marked as half price the chances are that we will buy that item, all other things being equal, at the expense of the item at a normal price. It seems to make little sense to ignore that process when applied to the world of investing.
One way to look at this is to imagine a stock market that had total earnings of £100 and an average PE of 10. Half the stocks would be expensive and half of them cheap. Let's assume the PE of the expensive half was 11 and the rest were valued at 9 time's earnings. So the market cap of the expensive half would be 550 and the cheap half only 450. That means an index fund would have 55% of its money in the expensive shares. As a result the investor is paying more than the average to own all those earnings. Expensive shares crowd out cheap shares.
Despite this problem trackers do not do a bad job and few active funds are able to beat them on a consistent basis. The benefit of low fees relative to an active fund goes a long way to compensate for the flawed logic of the process. Nevertheless, while the performance of passive trackers might be better than many active funds they will never beat the index. Worse than that though none of them can actually replicate the returns of the index, and some are a long way behind. A drag of 0.5% a year might not sound much but if it occurs every year and is amplified by the negative impact of compound interest it will still make a big dent in the returns of a portfolio relative to the index.
This table on Citywire illustrates the difference between the index and the returns provided by a passive tracker fund.
Conventional passive tracker funds might be better in some respects than active funds. But they have their flaws and we think there is a better way of tackling the problem.