ETFs, better known as market trackers, do what they say on the tin. They buy all of an index to allow you to track the performance of that market.
Take the FTSE for example. Buying a FSTE 100 tracker would give you ownership of every company in the FSTE 100. The amount of each company you own is weighted to the market cap of that company in that index. You can buy a tracker for any index around the world, allowing you to invest in any market.
The theory is that this provides the ultimate diversification method to spread your investment. However, do you really want to own every company within the index? Many of them may be there due to size and not because they represent good value.
Challenging stock holdings in trackers
For an example, let’s look at Centrica. The utilities company is a FTSE 100 listed company. However, it faces considerable challenges in the future with the UK government considering energy bill caps. This could have a serious impact on the way they do business and ultimately damage the share price. Is this really the best time to be investing in this type of company?
The same theory applies to other trackers around the world, and more specifically emerging market trackers.
Trackers and emerging markets
Emerging markets are a great addition to any portfolio, and offer the opportunity to make great returns. However, they can be volatile and fund managers view them as an inefficient market.
They are labelled “inefficient” due to the lack of reporting that they are required to complete. This can lead to information being held back that may have an adverse effect on the share price. Knowing the market and understanding the political system is the only way to navigate these markets successfully. And that is why a much higher percentage of fund managers outperform the index in emerging markets, than in efficient markets such as the S&P.
This begs the question, are trackers right for every market?
Trackers in efficient bull markets
The S&P for example makes up 60% of a global market tracker. And 16% of that is in top tech and healthcare companies such as Apple, Microsoft, Pfizer and Amazon. All of these companies are well reported, and the indexes they form part of are some of the most highly regulated in the world. This fair playing field has made it very hard for active managers to beat the market over the last seven years. This adds weight to the opinion that trackers do work in the right index.
A benefit of active fund management
Typically, when markets are rising, trackers do very well. However, if a market starts to level off or even pull back, the autopilot doesn’t kick in and you can give gains back as quickly as you have made them. Protection against this is an essential feature of active management.
A popular type of active manager is a Discretionary Fund Manager (DFM). These managers are a bridge between both active and passive and hold both of these types of investments in your portfolio. They create the right balance between the two options and can move funds between the two, subject to market conditions. This keeps the overall costs down and gives investors the best of both worlds.
In a rising market, they may hold more trackers, however, if the market starts to fall they are there to catch it and move funds back to safe havens. This is why active management (DFM) typically outperforms passive in periods of level or falling markets.
Could trackers contribute to a future market crash?
If the market started to pull back, an ETF investor would need to sell their entire holdings in that index to come out of the market. This no doubt would further fuel the fall which may encourage other ETF holders to exit as well. The result of which could create a perfect set of conditions for a future market crash.
If some of these listed companies are being held up by the volume of money from ETFs, where would the share price end up if that ETF money was removed?
Of course, this is simply speculation and markets may continue the bull run they have been on. But are you willing to risk it?
Consistent periods of market highs are not normality and investors should not get complacent and think this is the new norm. With interest rates slowly recovering, the flow of funds could start to move back into long-term interest and reduce demand for equities.
This brings me to the conclusion that there is no correct answer when looking at active vs passive. In fact, the way we have been looking at this question seems to be all wrong.
The best way to get the right balance is a carefully weighted mix of both Active and Passive.