They’ll tell you owt: the attack on index funds

When a new product emerges that cuts costs for consumers, it usually gets a broad welcome. But there is always a vested interest that opposes it, mainly from the high-charging sector that is being supplanted.

So it is with index funds, the collective savings vehicles that aim to mimic a benchmark, such as the S&P 500 index or the FTSE 100. Index funds were first offered in the 1970s but it is only in the past decade or so that usage has boomed.

The drumbeat of opposition to these funds is getting louder. Index funds are “dumb money”, leading to “herding” in the market and the misallocation of capital; companies are not being properly monitored and the market has become inefficient.

There is a saying in the north of England, where I was born, that “they’ll tell you owt” (anything). Yes, of course, for retail investors to madly rush into stockmarkets, without assessing the risks, would be bad. And yes there are some assets where indexing makes a lot less sense. But most of the arguments don’t stand up to scrutiny.

Let us start with the fact that most people should own equities as part of their long-term savings. The historic returns from shares have been higher than those from bonds or cash. While future returns won’t be as high, they should still offer a premium over safer assets.

From the point of view of consumers, index funds are the cheapest option. Around 75% of UK equity funds underperformed their benchmark over 10 years, along with 85% of European funds and 87% of US funds (source: S&P Dow Jones Indices). That’s OK, you might say; you will pick the best performers, not the average. But how? Performance does not persist. Of the top 25% of US equity funds in the year to March 2016, just 8% stayed in the top quartile over the following year and just 2.3% in the year after that. Those figures are lower than chance suggests.

Maybe, say the detractors, but the index funds just dumbly buy stocks regardless of their price. Indeed, but so do a lot of active managers. Let us go back to the example cited in a recent piece in the London Times; the dotcom bubble. That was an era when index funds owned a much smaller part of the market than they did now. Investors piled into actively-managed tech funds which when the bubble burst lost 90% of their value.

As for valuation excess, the UK market traded on a dividend yield of just 2.1% then; now it is 3.6%, a decent yield at a time of very low rates on cash. In America, the cyclically-adjusted price-earnings ratio reached 44 back then; it is a (still pricey) 32 now. Active managers can create bubbles.

If the stockmarket had been driven to absurd heights by index-buying then companies would be falling over themselves to float. But there were only a third as many flotations last year as in 1999; companies are buying back shares, not issuing them.

What about a lack of oversight of companies? The active era of the late 1990s had Enron, Tyco, Worldcom and others. Now companies complain about the power wielded by activist investors and Elon Musk is so fed up with his shareholders that he wants to take his companies private. There may be a problem of oversight if index funds get 85% of the market. But we are a long way from that.

What about the idea that investors don’t understand the risks and will bale out of funds in a downturn? Nothing is impossible but retail sellers were not the main problem in 2008. For those who invest in a broad stockmarket index, there is usually lots of liquidity.

Where there might be a problem is in corporate debt. It makes less sense to buy a fixed income tracker, which, by definition, will have its biggest position in those companies that have borrowed the most. Corporate bonds are less liquid than equities and may be difficult to sell. And companies have been splurging by issuing record amounts of debt because yields are so low.

Yes, if the stockmarket collapse because of Fred tightening or Trump’s tariffs, investors in index funds will lose money. But so will those who buy active funds. If you think that is going to happen, don’t buy equity funds at all. But if you are buying equities for the long run, index trackers are your best bet, as legendary investor Warren Buffett accepts.

Economist columnist, opinions generally my own, typos always my fault. Author of Paper Promises, The Last Vote and The Money Machine

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