{"id":56137,"date":"2017-05-29T10:47:35","date_gmt":"2017-05-29T10:47:35","guid":{"rendered":"http:\/\/ppmfunds.wpengine.com\/?p=56137"},"modified":"2017-07-19T01:20:45","modified_gmt":"2017-07-19T01:20:45","slug":"index-funds-the-untold-risks","status":"publish","type":"post","link":"https:\/\/www.ppmfunds.com\/index-funds-the-untold-risks\/","title":{"rendered":"Index Funds \u2013 the untold risks"},"content":{"rendered":"

\"\"A discussion by Hugh MacNally, Chairman of Private Portfolio Managers<\/strong><\/p>\n

\n

The advocacy of index funds has reached fever pitch. However, the critical element omitted in this discussion is the fundamental risk that is being taken by these funds. Private Portfolio Manager\u2019s 20 year performance track record provides clear rationale as to why you don\u2019t want to trust your portfolio to a risk unaware formula tracking the index. Hugh MacNally, PPM Chairman and Portfolio Manager shares his views and questions investors understanding of the risks of index funds.<\/p>\n

Significant index fund inflows <\/b><\/p>\n

Currently nearly 20% of domestic Australian share funds are invested via Index strategies and their share of the market is rising as indicated by the graph below. In the US this market share is approximately double the Australian market.<\/p>\n

The arguments for Index Funds\"\"<\/b><\/p>\n

The argument for using an index fund is usually along the lines that no manager beats the market consistently so why pay active management fees? Masses of data argue that the average cannot be higher than the average, so the best solution is to go for the lowest cost. Any advantage that a strategy might have is temporary and will be competed away. To argue otherwise is heresy; the earth is the centre of the universe!<\/i><\/p>\n

A risk assessed perspective \u2013 active management matters<\/b><\/p>\n

Our point of view is that a well-structured investment process that addresses the fundamental risks is absolutely vital and that to absolve oneself of this responsibility is professionally irresponsible. Assuming that one piece of data entirely describes the quality of companies is patently ridiculous; Index strategies use the capitalisation or size of the company (but one could equally pick any number of other arbitrary bases). We would argue that Index Funds ride on the back of the decisions of active managers and that the Index Funds are essentially a form of momentum strategy dressed up \u201cin vestments<\/i>\u201d (pardon play on words).<\/p>\n

Let us see what risks Index Funds are taking when the investments are chosen by applying one criteria and taking no account of any other characteristics.<\/p>\n

In many small markets, such as Australia\u2019s, capitalisation weighted indices are inherently risky as there are just a few large companies that have abnormally large weighting in the Index and thus in Index Funds. In Australia, in the ASX300 (a commonly used basis) nearly 60% of the Index is in two industries: finance and resources and at times in the past they have been a much higher proportion. The top 10 companies represent 47% of this Index, these are currently: five banks, two grocers, Telstra, BHP and CSL.<\/p>\n

The concentration risk and interdependency is totally unacceptable to PPM\u2019s investment philosophy. Out of these 10 stocks our core domestic portfolio has investment in only 5 representing less than 30% of the value of the core domestic portfolio; even then we are a little uncomfortable. In our view four of the ASX top 10 stocks have insufficient capital to support their businesses in a serious economic downturn, one is getting badly disrupted, one has a pitiful record of mal-investment and at least one is grossly over-priced.<\/p>\n

These characteristics above pretty much cover the three capital offenses against our investment process, that is, investments should: have strong financial structures, be in attractively structured industries and be attractively priced.<\/p>\n

So, let\u2019s put half your portfolio into that lot for the sole reason they are big. Is there really a problem in practice? After all these are household names. If we wound back the clock 30 years to 1987 (the first market crash that I experienced as a fund manager), of the top 20 companies, 9 of them went broke or disappeared to microcaps soon after. Names that might be remembered are: Bond Corp, Bell Resources, Bell Group, Elder IXL, Adsteam, Clayton Robard (a listed funds manager capitalised at more than Westpac!), MIM and TNT. Many had appalling fundamental characteristics or were grossly overvalued. An Index Fund would have swallowed these grenades whole. If Index Funds had represented 20% of the funds management market there would have been no liquidity for them to \u201cre-balance\u201d when the \u201cASX 300\u201d was rebalanced. <\/span><\/p>\n

The essential problem with having an investment strategy that has no fundamental underlying logic is that when the true fundamentals are laid bare there is a discontinuity and the assumptions that had underlain the approach disintegrate.<\/span><\/p>\n

If you think your Index Fund is immune because it will magically exit let\u2019s see them all try and get out at the same time when they represent 20%…30%…40% of the market (as they do in the US). Lack of liquidity might be their problem. <\/span><\/p>\n

If you are in any doubt as to the risk that passive funds take in this modern era, in our next issue of PPM Insights will model what a Lehman moment in Australia would do to your ASX300 based passive fund (the bankruptcy of Lehman Brothers bank was the starter\u2019s gun for the GFC).<\/span><\/p>\n

Ultimately, in the long term, the investor\u2019s interest is in absolute return (that is the dollars earned) rather than relative return which measures how a manager went against their peers or some index. The two are very different; the first is what the investor gets, the second is partly a marketing tool and related to the managers\u2019 business model (XYZ fund was the best performer over 12 months etc) or for the charging of performance fees. Mainstream funds managers tend not to stray too far from their benchmark Index as this runs a business risk, that is, the risk of underperforming their peers and ending up in the relegation zone. Their concept of risk is underperforming their peers not the customer\u2019s risk of loss of capital.<\/span><\/p>\n

There also seems to be a psychological twist to the Index argument, not really expressed in the pages of supporting statistical analysis, and that is that Index Funds are in some way lower risk by not having a human make any decisions; perhaps this is reflective of the era\u2019s self-doubt of human judgement (given the political masters we choose we should<\/i> have some self-doubt!).<\/p>\n

\n

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The advocacy of index funds has reached fever pitch. However, the critical element omitted in this discussion is the fundamental risk that is being taken by these funds. Private Portfolio Manager\u2019s 20 year performance track record provides clear rationale as to why you don\u2019t want to trust your portfolio to a risk unaware formula tracking the index. Hugh MacNally, PPM Chairman and Portfolio Manager shares his views and questions investors understanding of the risks of index funds.<\/p>\n","protected":false},"author":1,"featured_media":56139,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[63],"tags":[],"class_list":["post-56137","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-ppm-insights"],"yoast_head":"\nIndex Funds \u2013 the untold risks - Private Portfolio Managers<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/www.ppmfunds.com\/index-funds-the-untold-risks\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Index Funds \u2013 the untold risks - Private Portfolio Managers\" \/>\n<meta property=\"og:description\" content=\"The advocacy of index funds has reached fever pitch. 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