Enthusiasm for index funds could prove costly in the long term

There has been a huge amount of media commentary on the relative merits of active versus passive investing, particularly in relation to KiwiSaver funds.

Most media commentators, including Weekend Herald columnist Mary Holm, argue that passive KiwiSaver funds are better because they are cheaper.

Holm maintains that active funds underperform passive managers on an after-fee basis, mainly based on United States research, and she repeatedly encourages individuals to invest through passive funds rather than active funds.

But this debate should also include an assessment of fund managers as financial intermediaries. The argument should not be about fees only.

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Financial intermediaries play an important role in the modern economy as they attract savings from individuals and invest this money in businesses that utilise capital most effectively.

The country's largest financial intermediaries are registered banks, with total assets of $509 billion. They are followed by fund managers with $106b of consolidated assets, and non-bank financial institutions, including finance companies, are in third place with $14b of assets.

Registered banks are far more profitable than fund managers and non-bank financial institutions.

For example, the five largest registered banks have reported net earnings after tax of $4.49b for the latest 12-month period while the five largest fund managers had net earnings of only $91 million according to Companies Office filings.

Reserve Bank figures show that the country's registered banks had net earnings after tax of $4.98b in the latest 12-month period, while the fund management sector probably had net earnings well below $200m.

The role of registered banks as financial intermediaries is to accept deposits and lend this money to individuals and companies that can meet their interest payments and repay their loans. Banks undertake considerable risk and credit analysis to ensure that borrowers can meet their obligations.

In other words, banks take an active and analytical approach towards financial intermediation.

At present, the registered banks have $226.4b lent on residential property compared with $124.2b a decade ago. These figures clearly indicate that financial intermediaries have a major impact on a country's economic activity, particularly residential property.

Registered banks are far more profitable than fund managers and non-bank financial institutions.

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New Zealand's deposit taking finance companies crashed and burned nearly a decade ago because they adopted a relatively passive approach towards lending, namely poor risk and credit analysis. They effectively watched Hanover Finance and Bridgecorp Finance lending to property developers and followed suit.

Finance company depositors suffered massive losses because of this relatively non-analytical approach.

As far as KiwiSaver and PIE funds are concerned, active fund managers undertake specific company analysis and make their investment decisions based on this research.

By comparison, passive managers undertake no company analysis and make all their investment decisions based on the weighting of companies in benchmark indices. If a company represents 10 per cent of a benchmark index, then a passive fund will invest 10 per cent of its money in this company, regardless of its prospects.

A passive fund benchmarked against the NZX50 Gross Index will allocate 9.39 per cent to Fletcher Building, because that is the company's index weighting, 8.35 per cent to Spark NZ, 7.64 per cent to Auckland International Airport, 6.02 per cent to Fisher & Paykel Healthcare and 5.29 per cent to Ryman Healthcare.

The NZX, which is a major supporter of passive funds, would be allocated only 0.35 per cent in a NZX50 Gross Index benchmarked passive fund because of its low index weighting.

Active managers are disadvantaged by this approach because they employ security analysts, and consequently have a higher cost structure, while passive funds essentially undertake no analysis.

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Passive funds are growing rapidly but they still represent only 30 per cent of total funds in the United States. Passive funds will continue to gain market share because regulators are determined to drive down management fees. Active managers are disadvantaged by this approach because they employ security analysts, and consequently have a higher cost structure, while passive funds essentially undertake no analysis.

It can be argued that passive fund investors are freeloaders because share prices are set by active investors while passive funds just follow them without undertaking any analysis to determine whether these share prices are fundamentally justified.

But what happens if passive funds achieve a 50 per cent, 70 per cent or 90 per cent market share? Who will establish realistic market prices if this occurs? Will passive funds just follow each other without any analysis?

This is what happened to New Zealand's finance company sector in the early 2000s: there was little in-depth credit analysis and these companies just followed each other by lending to highly speculative property developers.

There is little doubt that passive funds have a strong chance of outperforming active funds in the short term if investors continue to flood them with money. This is because passive funds pour money into the largest stocks and the heavy weighting of these companies drives benchmark indices higher.

For example, the five largest Nasdaq 100 companies - Apple, Microsoft, Amazon, Facebook and Google - represent over 30 per cent of the index's weighting and these stocks are attracting approximately one-third of the money invested in passive funds that are benchmarked against the Nasdaq 100 Index.

These passive funds are beginning to have a huge impact on the NZX, as demonstrated by trading on Wednesday, the last day of November.

Total market value was $267m, nearly double the daily average of $150m. But the most interesting point was that 53 per cent of the day's volume of the seven largest companies was done at the market close. This is because passive funds rebalance at month end and on market close.

Wednesday's highlights included:

• Spark's volume of $52.1m. The stock was up 3.6 per cent and 64 per cent of the day's volume was done at the market close. The telco's shares gave up most of Wednesday's gains on Thursday.

• Fletcher Building traded $37.3m on Wednesday. Its share price was down 4.8 per cent with 40 per cent of the day's trading executed at the close. The stock recovered 1.6 per cent on Thursday.

• On Wednesday, The Warehouse traded 853 per cent of its average volume over the previous 30 days as it was removed from the MSCI Small Cap Index. Spark traded 359 per cent of its average daily volume and NZ Refining 309 per cent.

These figures clearly show that sharemarket trading will become more and more volatile if passive funds continue to increase their market share.

The figures also demonstrate that if markets fall, and nervous investors withdraw their money from passive funds, then this could have a devastating impact on global sharemarkets. Passive funds can look extremely attractive when money is pouring in and markets are rising, but they can be very unattractive when the opposite occurs.

The sustained growth in passive funds has a number of implications for New Zealand including:

• We don't have large, low-cost passive funds, so a higher percentage of the country's KiwiSaver and PIE funds will invest offshore.

• The NZX will become more and more volatile, particularly at month end, as global passive funds rebalance their portfolios.

• More money will be invested in large listed companies and less in small NZ companies because the latter are not included in global indices.

The huge enthusiasm for low-cost passive funds could be extremely short-sighted. This is because cheap products can look attractive in the short-term but are often less attractive than expensive items on a longer term basis.

It is also difficult to believe that financial intermediaries, which play an important role in allocating the country's savings, can be successful over the longer term without undertaking any detailed analysis.

Non-analytical, follow-the-crowd investment strategies have not been successful over a sustained period in the past. Do diehard passive fund supporters really believe this approach will be successful in the long term?