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November 2017

The indexation wave

What if index-tracking becomes the dominant form of investment?

Rarely has the cost of investing come under such scrutiny. And rarely with such sustained intensity. With most active equity portfolios having failed to beat their benchmarks since the 2008 debt crisis, regulators and investment consultants seem to have lost patience with the large number of funds whose persistent underperformance is matched by their persistently high fees.

So too has the financial press. The growing disillusionment with actively managed funds and investment gatekeepers’ focus on cost are transforming the financial landscape. Passive investing is firmly in the ascendancy.

Since the end of 2007, passive exchange-traded funds (ETFs) have accumulated a net USD1.7 trillion of investment inflows. That contrasts with the USD1.2 trillion drained from actively managed vehicles over the same period. From the perspective of an individual investor, the shift makes sense. Index-tracking funds charge lower fees. And it is also true that they have delivered better returns than the average actively fund after investment charges.1

Problems are sure to arise, though, if indexation becomes the dominant form of investment. In such a scenario, it is not clear whether the financial market will be able to allocate capital efficiently. Nor is it certain that corporate executives will be held to account. There is also the prospect of entire industries falling under the control of just a few passive investment firms – a development that could erode the pillars of the free-market economy and stifle innovation.

The enthusiasm for index-tracking is born out of regulators’ and consultants’ desire to control cost. That is a laudable goal. But the longer-term costs that will emerge from the continued expansion of passive investment have not been properly assessed. If the majority of investors embrace them, index-trackers threaten to sabotage the very system upon which they were built.

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