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Passive and index-tracking funds can pose major problems for investors

Index-tracking and passive funds are not the whole answer for investment portfoliosIndex-tracking strategies have continued to grow in popularity among UK investors over the past decade despite that fact that the UK market is becoming less suited to passive investment.

Institutional investors, the original proponents of index tracking, have diversified their asset allocation into other areas, increasing their investments overseas, and investing in alternative assets such as private equity, property and hedge funds. In addition, institutions have demanded new indices where the single biggest holding would be capped at 5 per cent. Most private investors have done little or nothing.

It is worth looking at passive investing more closely to see what the limitations can be. Index funds use the market capitalisation of each company to determine the percentage of your investment they will invest in each stock. The problem is that the indices are based on the size of the firms that happen to be listed in that market at the time.

The UK equity market has evolved hugely over the last 20 years and a few sectors have become unusually large. This gives index investors a problem – they no longer hold a diversified portfolio and so the risk of holding an indexed portfolio increases. Passive investments will track the market down as well as up and underperform in both directions because of charges.

If the positive trends driving, for example, the resources sector continue this increased risk will be good news because the excess exposure will generate more gains. But when the trend reverses, the opposite will be true and big losses will result.

An active manager, by contrast, should be able to recognise and react to such changes, for example, moving a proportion of a portfolio into value investments in certain market conditions and switching back at other times to growth stocks. For example, the average UK income funds fell less than half of the FTSE All share in the years 2000 to 2002 after all expenses. So a switch of just a proportion of assets would have been beneficial.

At stock level, risk has also increased. A number of highly successful global companies are listed in London. They are many times the size of domestic companies and index funds invest in them which means that although the index contains enough companies in enough industries to construct a well diversified portfolio you will not get one. Some 50 per cent of an index investor’s money will be invested in the biggest 14 companies, with nearly 21 per cent in just three. Two holdings will each be over 8 per cent. A decade ago, the biggest stock was still under 4 per cent of the index. The risk may work for or against you but is something you neither want nor need.

With risk at UK market, sector and stock level highs by historic standards, institutions have sought to reduce risk via several routes. The most conventional has been to invest globally. This makes sense because we move from a situation where we are investing in a limited selection of global companies listed in the UK to a bigger range of global companies listed globally. Exposure to currency fluctuations will increase but over the longer term this generally has surprisingly little impact. The ability to substitute a global US or European company for a UK-listed equivalent can be highly desirable for active investors. Where a global company is listed should not be the determining feature of an investment strategy.

The increasing trend back to active management is underpinned by good reasons. The increased use of hedge funds and derivatives’ products such as contracts for difference has added to the lack of efficiency in markets with large positions being taken as a speculation rather than an investment. Volatility seen in markets at “option at expiry” time is evidence of this inefficiency.

This significant structural change in the equity market over the last two decades increasing sector and stock-level risk means that indiv-idual investors need to forget the marketing hype of the 1990s for passive fund management and act sooner rather than later to avoid an unwelcome surprise.

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