Bonus chapter: Are index funds threatening the health of the world’s securities markets?

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* This article is for those people with a deeper appreciation for securities market theory. If you would simply like to decide which pension fund is suitable for you, you can jump directly to the end.

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Today’s Luddites are not textile workers, but rather white-collar investment bankers, whose sweet bread is being stolen by smart computers.

In global, and recently also Estonian, media, one can regularly read statements on how the growing popularity of index funds is a threat to the health of securities markets. The tone of these statements ranges from prudent scepticism to apocalyptic hysteria about something that is unknown. A recent Bloomberg article referred to exchange-traded funds (ETFs) as “weapons of mass destruction”.

So, what exactly is it that these index funds are destroying on a mass scale?

An index fund invests passively. This means that the fund manager divides your money proportionately between the securities of the world’s largest companies and governments. In this way risks are well-diversified and you are ensured a result that is close to the market average.

Computers are taking jobs away from the worst fund managers

In the case of a fund with an active investment strategy, the fund manager attempts to select securities and to buy low and sell high.

Statistics show that most active fund managers are unable to achieve a result equivalent to that of index funds or even beat the market average over time. In the article published by Bloomberg, FPA Capital fund managers have thus far been unable to do so. In Estonia, the results of actively managed pension funds and investment funds belonging to other banks have also systematically remained below the market average.

Incidentally, Morningstar, one of the world’s largest investment research companies, has also rated Estonian investment funds. Some funds have also emblazoned their homepage with Morningstar Rating’s two stars (Note – the link no longer works as the fund has been liquidated – 29.Aug.2019). Two stars may appear grand – for example, a restaurant with two Michelin Stars will provide you with an excellent dining experience. However, in the rating system for funds, two stars indicate a below average result.

High-paid fund managers have a powerful voice and great motivation to fight against the growing popularity of passive investing. The clearer it becomes that most of them are personally incapable of offering value to investors, the greater the fear over the potential loss of income and employment.

The world’s investment banks have already fired a large portion of their securities brokers and analysts, since computers are better at performing their jobs. For example, at its height back in 2000, there were 600 traders employed at Goldman Sachs’s New York US Equities Trading desk. Today, there are only two left. The experience of one of the world’s biggest investment banks is that an average of four traders can be replaced by one IT engineer, who then develops the algorithms necessary for making buying and selling decisions.

Automatically managed funds do not differ from self-driving cars

We are standing on the threshold of another industrial revolution. This time, machines will not only be replacing low-wage physical labourers – a large number of white-collar workers will also end up losing their jobs.

Take note: many people are ready to declare as progress, without any criticism whatsoever, the serious matter of millions of drivers being threatened with the loss of employment, since cars of the future will be self-driving. Frequently, it is those techno-optimists in particular who see the end of the world approaching when their job in a bank, seasoned with the magic of finance, is threatened.

The changes that are brought about by the development of technology can and must be discussed. Including those connected to the securities markets. The fear that the growth in the popularity of index funds may bring along with it problems includes a number of presumptions, the validity of which must be questioned. I don’t know what the future of the world’s securities markets will end up being. And I have never met anyone who did.

An active investor is not necessarily a smart investor

I have yet to come across a convincing argument which would provide a reason to consider it possible that, for example, some other strategy may be better for Future pension fund investors than the passive, index following strategy. But these arguments must be constantly searched for, since in the case of an index strategy the modesty of the approach is attractive. Passive investing is not surrounded by rakish bravado or the myth of an experienced genius. As an index fund manager, I am unable to harm my investors in the way that an active fund manager who is too self-confident or afraid can; even so, I must continuously call my knowledge into question.

Based on what I know today, I believe that the spreading of index funds could make markets more, rather than less, efficient. Why?

Some believe that the more popular those funds whose managers fail to engage in forecasting become, the more inefficient the market becomes. Because surely somebody in the company should be following the market and assessing how the company is performing. In the opinion of others, it is quite sufficient if only one-tenth of the money is in the hands of “informed” investors.

The question of whether investors are indeed such rational calculators, as is presumed by the efficient market hypothesis, is one that has been discussed by financial academicians for decades. It seems that investors – including fund managers – are often short-sighted and emotional, tend to run in herds, etc. Yet, the markets have managed to cope so far. Will index funds change anything in this plan?

When asking about whether index funds threaten the health of markets or not, it is worth remembering why index funds are growing so quickly in popularity. It is likely because the managers of actively managed funds generally lack the skills necessary to bring investors profit.

Although there are individual funds that are successful. Is there reason to believe that their success is something more than pure chance, that they really do possess exceptional expertise? If yes, then it should be good news when the poorest of the actively managed funds – those which are continually getting in the way of the market – are replaced by index funds. Thanks to this, the average skill level of remaining fund managers grows. Vulgarly express: the market sullying hacks find themselves unemployed and deprived of their investors’ money. The market becomes more efficient.

The more efficient the market, the lower the likelihood that active management provides a better result

The more efficient the market, the harder it is for active investors to ‘beat the market’ or earn above average results. Beating the market is a so-called zero sum game. In order for you to be above average, someone else has to be below average. The more popular active investing is, the greater the likelihood that at least half of investors are dumber than you. If the majority of investors select an index fund and all that is left behind are individual highly qualified active investors (since the majority of others have already lost their jobs), then competition takes place at a higher level.

In other words: following an index gives the majority of investors an increasingly higher likelihood of achieving better results than active management.

Who should select an active fund and who should select a passive fund?

The likelihood that active management will yield a result that exceeds the market average is shrinking, but will never disappear completely. In order to select between an active fund and a passive fund, it pays to ask some questions. If you are able answer all of the questions affirmatively, select an active fund. If the answer to even one of these questions is ‘no’, then select a passive fund.

  1. Do you have reason to believe that your experiences and knowledge permit you to correctly decide which fund manager is better than the others?
  2. Do you have reason to believe that among those fund managers, in particular, among whom you are selecting, there is one who is smarter than the rest of the global market? Better than the Estonian average will, unfortunately, not be of help to you here, which is confirmed by our lacklustre pension fund history…
  3. If you have reason to believe that your fund manager is smarter than the rest of the market, then does the added value that their wisdom provides justify the higher fees? Today, the difference in cost between Estonia’s most expensive and most affordable pension funds is nearly two per cent. It is difficult to achieve a slightly higher than market average return, while achieving a year to year return that exceeds two per cent or more is already very, very difficult to achieve.

It is worth remembering one more thing: a very large portion of the world’s funds are behaving and have behaved for years in a manner quite similar to that of index funds. Funds attempt to differ from their market average as little as possible. For the simple fact that a loss doesn’t look so bad if everyone else is also in the process of losing. This phenomenon – a so-called closet index fund – has, thanks to the arrival of index funds with a clearly stated strategy, also become an object of interest to the financial supervision authorities. Many ‘actively’ managed funds do not differ very much in actuality from the market index, although they charge a high price for the service. This problem has also not received enough attention in Estonia.

Leading economists find that the smartest thing is to save for one’s pension through a low cost index fund. An increasing number of investors in the United States are taking that advice to heart – at the end of 2017, more than half of their investments should be in index funds.

Whether we, here in Estonia, choose an index fund or a high-cost fund managed by hand is only affected by the size of our pensions and perhaps the amount of profit of local management companies. Developments on global securities markets do not affect the decisions of the people of our tiny country. Therefore, the decision between an active or passive strategy fund can be confidently made based on some rather egotistical factors.