The dangers of index investing
Writing in the Financial Times (17th February) the boss of fund management group Fundsmith, Terry Smith, asks why investors are pouring money into funds that track emerging stock market indices. These tracker funds invest in shares according to their market capitalisation, so they invest most in the big companies, which in emerging markets are often inefficient and partly state-owned. Mr Smith says the ten largest emerging market companies earn well below-average returns for their shareholders, so they are not shares that quality-conscious investors like him want to buy.
So long as the money pours into these tracker funds, it will drive up the share prices of the index constituents. As Warren Buffett has often remarked, in the short term the stock market is a voting machine – share prices simply respond to buying orders. In the long run, though, the stock market is a weighing machine – it weighs the returns shareholders get in the form of profits and dividends. The best companies make the biggest returns for shareholders – think Apple or Google, which have multiplied early investors’ money hundreds of times – and active managers do their best to find and buy tomorrow’s Apples or Googles today, when they do not form part of the stock market indices.
We agree entirely with Mr Smith. We think index investing is mostly dumb. It involves buying yesterday’s heroes when investing success is all about tomorrow’s winners. Instead we generally recommend actively managed funds whose managers have clearly defined methods, ideas or target sectors of the economy where they expect to make their investors serious money.
Actively managed funds will not always do better than index tracking funds. But if you feel sceptical about TV ads along the lines of ‘A million housewives can’t be wrong’, then you should be equally sceptical about index tracking funds. ‘The crowd’, according to most of the great investors, is usually wrong, and that is a pretty good reason for not joining it.