Why You Shouldn’t Invest In Index Funds

Posted on 02/05/2011

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I’ve recently spent some time looking at the Glencore flotation and its implications for the composition of the FTSE-100 index and therefore, in turn, the investors in index funds which track the FTSE-100.  I’ve now done some further work on the inherent biases of index funds and have come to be broad conclusion that they are best avoided by those who have a reasonable level of competence in investing.  I have set out my reasons below.

A market capitalisation-weighted index gives larger weightings to more expensive companies (valued relative to their earnings/assets) and smaller weightings to cheaper companies.  As companies become more expensive with higher price/earnings and price/book ratios, they gain higher weightings in the index and consequently index funds have to increase their holdings, selling their holdings of cheaper companies in order to do so.  An index fund is therefore an automatic mechanism to buy high and sell low.  I don’t recall this tactic ever being previously given as good investment advice.  The chart on the right, sourced from Doddsville, shows how Credit Corp was added to and then removed from the the Australian stock indices.  Although an extreme example, index funds are making similar economic transactions every day.

Not only does an index fund have larger weightings in more expensive companies (relative to cheaper companies that earn similar-sized profits) but also in larger companies relative to smaller companies.  The result of this is the index funds tend to have the most significant portion of their assets in large, mature companies.  The problem with this its that the largest companies in a stock market index are yesterday’s winners – they got to be the largest by delivering exceptional returns to investors over the course of many years.  However, given the way industries develop, grow, mature and then decline – as shown in the chart below right – it is likely, barring a major reinvention led by a strong management team, that these companies will earn much lower returns in the future.  An index fund is therefore mainly a portfolio

of major mature companies, many of which only have years of decline ahead of them.  For example, Eastman Kodak – a company whose business model was significantly undermined by the introduction of digital photography technology – was removed from the Dow Jones index in April 2004 at a share price of $26, some seven years after the price peaked at $90.  Similarly, Genernal Motors wasn’t removed from the Dow Jones until it was nearing bankrutpcy in 2009, the share price having fallen from a peak of $93 in 2000 to $10 in late 2008.  The as-yet-unidentified companies likely to achieve high total shareholder returns in the future are unlikely to be amongst the mega-cap stocks that dominate the indices and therefore also the index funds.  Consequently, by buying into index funds an investor is putting a not inconsiderable proportion of his portfolio into mediocrity and decline.

The make-up of market indices is only partially determined by active investors, who by trading in the shares of the constituent companies thereby determine their prices and therefore influence the index weightings. The index constituents are often determined by the companies themselves, as the stock market on which they choose to list their shares leads to their inclusion in a particular index.  Glencore, by recently choosing London as its primary listing, will go straight into the FTSE-100 following the completion of its upcoming IPO.  If it had chosen Hong Kong as its primary listing, it wouldn’t have been eligible for the FTSE 100 at all.  Clearly, companies choose the stock market where they think they will be able to get the highest price.  Index investors are then forced into paying that high price.  There is no rational justification for the assertion that the choice of a group of company directors as to where they should list their company should influence your portfolio construction.  However, if you invest in index funds, that is the decision you are making.  For example, if you were to buy a FTSE-100 index fund you would not just be buying into the biggest UK businesses, but also into a wide range of emerging market commodity businesses such as: Antofagasta (Chile); Essar Energy (India); Eurasian Natural Resources Corporation (Kazakhstan); Fresnillo (Mexico); Kazakhmys (Kazakhstan); Lonmin (South Africa/Zimbabwe); Randgold Resources (Mali); Tullow Oil (Ghana & Uganda); Xstrata; and, soon, Glencore.  Each has little or no connection with the UK, and just because these companies have decided to list on the London Stock Exchange doesn’t also mean that they should be in your portfolio.  In other words, markets that place the highest valuations on particular companies or sectors are likely to be adverse selected against by the companies and their directors.

The automatic trading rules of the indices makes it very easy for active traders to front-run the index funds.  Each index has a set of mechanical rules which determine the stocks that will enter and leave a particular index each period.  Traders can observes these rules and buy the expected new entrants and sell the expected deletions, thus taking advantage of future buying/selling of the index funds.  Philip Hamill, Peter G. Dunne and Kwaku K. Opong found that stocks entering the FTSE-100 saw average outperformance of 5.2% in the five days leading up to entry, while stocks exiting the index saw underperformance of 6.65% in the five days preceding exit.  Therefore, the churn of the index constituents drags on the returns of index funds not only by way of trading costs, but also in the form of weaker index performance due to the front-running of active traders.

You would think that your index fund investment will be invested in the shares of the constituent companies, but that might not actually be the case.  Many index fund providers invest the cash itself in a random pool of collateral and then engage in a total return swap with an investment bank, swapping the return on the collateral for the index return (less fees).  Consequently if the total return swap counterparty becomes insolvent then the index fund investors will be left with the collateral, which may be illiquid and therefore difficult to sell, leaving them with an unexpected divergence versus the underlying index.

So in summary, if you’re invested in index funds, you’re almost certain to be over-invested in expensive companies relative to cheaper companies, have much of your cash in large-cap mature and declining companies, be adverse-selected against by savvy company directors, lose money to active traders on every index rebalancing, and potentially have your actual cash invested in dodgy collateral and be reliant on a total return swap with an investment bank.  In other words, best to choose your own investments in individual stocks.

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