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Jul 2, 2020

Blessed Are The Passive Index Managers And Creators, For They Shall Inherit The Earth

by David Ensor

David EnsorIt is a now almost a truism that a wise individual investor must be in need of a menu of low-cost index funds.

Various estimates by the Financial Times and BlackRock set the total at roughly U.S. $20 trillion, and when you include the closet-indexers in the supposedly “active” space the total may well be more.

Not only is the scale of indexing ever growing, but it is essentially an oligopoly, dominated by three companies, BlackRock, Vanguard and State Street, all U.S.-based. There can be no real argument against the fact that their presence and scale has been of enormous value to investors in terms of providing low cost alternatives to active managers, with the irony being that the latter are the price-makers—an index fund, by definition is a price-taker.

However, there is another, less visible oligopoly which is as equally important as the index fund managers, the index creators, principally MSCI, S&P Dow Jones and FTSE Russell—two U.S. and one a U.K./U.S. hybrid.

With two intimately-linked oligopolies being responsible for the design and performance of many of Canadian MoneySaver (CMS) readers’ investments, it would be wise to pay more attention to how they behave, what their incentives are, whether they have biases, and whether they are vulnerable to external manipulation or political pressure.

Arguably, because the goal of any asset manager is to control as many assets as possible from which to earn fees, the index managers’ motivations and behaviours are relatively predictable. The main question they face these days is how they will exercise their increasing voting power, and whether they will be pro-active in trying to guide how corporations create wealth sustainably and in ways that do not harm society or the environment. Given the concentration of power, this an important consideration for an investor who wishes also to be a “good global citizen”.

In reality, great power also lies with the index creators, because how they design, constitute and modify a particular index by definition affects its purpose and performance. For example, should an index be capitalization, equally or factor-weighted (e.g., value, growth, momentum and so on)? Is it a broad or narrow index; industry or geographically focussed? Does it explicitly or implicitly take into account matters such as ESG (Environmental, Social and Governance), shareholder voting weights or the level of a company’s “free-float” (i.e., the percentage of shares which are publicly-tradeable)? Adjusting any one component can make a radical change to how an index performs, while not necessarily being obvious to an investor.

And, because index exclusion or inclusion, affects the flow of capital into or from a particular industry, market sector or country, index providers exercise private authority (de facto regulatory power) with little or no oversight, while making decisions that seem increasingly (particularly when it comes to topics such as China, or fossil fuels) to cause politicians to foam at the mouth, and seek to interfere.

The key point in all this is that you, dear Reader, may have decided that creating an investment portfolio which is comprised exclusively or mainly of index funds is the best way to secure your future financial security. However, bear in mind that what you are doing is going through the process of portfolio construction, something which is fundamental to long term performance. So, that is your first decision: do you go active or passive?

Perhaps equally importantly, you then need to decide not only which managers you should employ, but which of their offered funds best suits your goals, which these days may well include areas such as ESG; in other words asset allocation.

To say that the number of available funds has proliferated, as has the range of indices they use, is an understatement. So, you need to look at the premise behind the fund (all the way from the very broad Vanguard Total Stock Market Index Fund to, say, the Horizons Marijuana Life Sciences Index ETF). In making your selection and allocation you should not simply choose the “brand” or “name on the tin”, but also read all the available fund documents so that you understand exactly what you buying. Never assume!

The title of this article may seem a little facetious, but, as an investor, you should always understand where the real market power lies and whether those who manage your investments have their interests aligned with your own, and are providing an investment whose design and purpose agree with your own intentions.

I have written before about how active fund managers are rarely fit for purpose; and believe strongly that the use of passive index funds is the best approach for most individual investors. However, that does not mean that that is the end of your decision-making process. It is merely the beginning!

David Ensor, Risk Consultant

david.ensor@btinternet.com