David Clark: The number of indices and thematic funds can be confusing for investors
I’m told there’s more than one way to skin a cat. I’m going to believe it because this kind of hobby does not appeal to me.
I am also told that there are many ways to approach investing in the stock market.
I know this to be true because I have tried quite a few myself. Most approaches have the dubious advantage of being useful once in a while but not all the time. Those who believe in a magical ability to make predictions based on examining stock price charts with clever technical analysis will be familiar with this.
In recent years, thematic investing has become more popular, although it is not a new idea.
For the benefit of the uninitiated, providers such as S&P or MSCI launch an index based on a certain theme, say mining or artificial intelligence or the FTSE 100.
It is hoped that these indices will attract exchange-traded fund (ETF) providers who will license these indices and replicate them with a new ETF.
Additionally, asset managers often launch their own funds that rely more on active management and fundamental analysis than the passivity of ETFs.
The most widely adopted theme in recent years has been the rise of ESG funds. This despite the fact that two people cannot agree on what actually constitutes an ESG fund. Remember the old adage – “Never let the facts get in the way of a good story.”
To be clear, I like index funds, with the same caveat that goes with all investment instruments; find out what you are buying.
They are not suitable for all markets and the less efficient a market is, the less suitable they are.
In an inefficient market, it is much more likely that active management and proper analysis and research of companies will produce superior investment performance. It is also true that an inefficient market will likely have more than its fair share of illiquid and expensive stocks.
ETFs and index funds have also contributed to significant fee pressures for actively managed funds, as passive funds are generally less expensive. As it happens, they’re not as cheap as they seem, but we’ll talk about that later. Additionally, the more index funds that replicate a particular market are available, the lower the flow of funds to actively managed funds.
I started thinking about this shortly after Russia invaded Ukraine. Amid general global outrage, calls have been made to exclude Russian companies from emerging market indexes.
It took a week for MSCI and FTSE to make the change and the changes only came into effect later. That meant emerging market index investors were stuck holding Russian stocks that fell more than 50% in a matter of days.
To add insult to injury, when ETFs came to sell the shares, trading in these companies had been halted on all Western stock exchanges and it was virtually impossible to trade them in Moscow.
In this case, although extreme, ETFs have caused great harm to their investors.
The Russian example is a bit unique (hopefully), but there are other reasons why ETFs might not make such large investments. Curiously, the major thematic S&P and MSCI indices are weighted against profitable “quality” stocks and value companies. This was shown in an article in the Journal of Beta Investment Strategies by David Blitz (Winter 2021). The article was pointed out to me and surprised me, as I bet it would affect a lot of ETF market participants.
This means that in essence, thematic indices are heavily skewed towards expensive and unprofitable stocks, so-called “glamorous” stocks.
Thus, passive funds that track these thematic indices are likely to invest in overvalued and overhyped stocks. It’s fine if overvalued glamorous stocks perform well, but if there is a shift in market leadership towards quality value stocks, then the more active manager can and probably will perform much better.
Every investor knows (or should know) that every study undertaken on the performance of value stocks shows their tendency to outperform the broader market over a decent period of time.
For the most casual market participant, the range of thematic funds and ETFs, as well as the number of indices that have been created can seem quite confusing and off-putting.
One might reasonably think that such a market would be competitive and that the prices would be advantageous, all other things being equal. Alas, this is the real world, all things are not equal and not necessarily what they seem.
The fees paid for a theme fund are typically well below half of what you would pay an active manager, so on the face of it they are perceived as good value.
The problem lies in two parts. The first is that if you buy an ETF, it will almost certainly come from one of only five providers that dominate the market (Ishares, Vanguard, StateStreet, Invesco and Schwab).
Second, these ETFs will track the indices of an equally concentrated group of providers, namely S&P Dow Jones, CRSP, FTSE, MSCI and Nasdaq. Ironically, despite the spirit of democratization associated with low-cost indexation, it is the victim of a set of classic oligopolies.
Consequently, index providers have significant market power and can charge high license fees.
Meanwhile, as ETFs are primarily a large-scale industry, smaller providers have limited ability to compete with dominant market players as they lack economies of scale.
The researchers estimated that 60% of index license fees are markups by index providers to ETF sponsors and that ETF fees could be 30% cheaper in a more competitive market.
Given that the prices are already low, this seems a bit odd. It seems that while ETFs are efficient, the ETF industry is not.
On second thought, maybe cat skinning would be easier.
David Clark is Chief Investment Officer at Saracen Fund Managers