This year, for the first time in the UK, a single company came to account
for more than 10 per cent of the stockmarket index. This may seem like a
technical factor, which it is, and irrelevant to the advisory market, which
This issue, if unchecked, will have a broader effect on the retail
Vodaphone Mannesman now accounts for more than 10 per cent of the FTSE 100
index. Authorised unit trusts are not permitted to hold more than 10 per
cent of a portfolio in any one stock, so the conclusion is that UK equity
funds will be forced to be underweight in Vodaphone Mannesman.
Clients who invest in a UK equity fund have the right to expect the fund
manager to select from the broad universe of shares and use their skill and
judgement to decide whether to be overweight or underweight in order to
deliver excess returns. But clients will not now have this expectation.
There is a more serious issue. FSA guidance following the Vodaphone
Mannesman deal indicates that index funds can breach the 10 per cent limit
if their fund objectives allow. Alternatively, index funds can use a
synthetic proxy. This is an asset which, while not a Vodaphone Mannesman
share, mimics the performance of this share.
Technically, because the Vodaphone Mannesman share and the synthetic
instrument are different assets, they are not aggregated and, therefore, do
not breach the 10 per cent limit. But the net effect is that the portfolio
has more than 10 per cent exposure to a single company.
In addition to this, Europe is developing legislation to allow index funds
to hold up to 35 per cent in one asset to cater for more concentrated
equity markets within the EU.
Autif and the data providers have long taken the view that products should
be segmented to meet the needs of clients and their advisers rather than
based on arcane technical detail. Consequently, UK actively managed and
index funds have been grouped together since they seek to deliver the same
basic proposition to investors but simply choose different routes to
achieve that objective.
However, if technical factors undermine this principle, the common
classification must be seriously challenged.
An additional side effect of this structural difference is that active
managers, who are already and, quite rightly, facing fierce competition
from index funds, will find this position exacerbated. In essence, active
funds rely on being able to convince investors that it is worth paying a
premium for excess returns. This premium not only justifies the costs of
fund management and research but also justifies the advice needed to select
a higher quality fund.
Now imagine an environment where the biggest stocks significantly
outperform their smaller peers. Index funds which hold these stocks will
outperform their active rivals. The current position, where index funds
claim that 80 per cent of active managers underperform the index, will
reach the point where potentially 100 per cent will fail this test. Combine
this message with the clear price advantage of index funds and the
situation begins to look decidedly sticky.
A defence may be to use the new range of capped indices. The debate with
capped indices is whether the biggest stocks are capped at 10 per cent to
comply with the rule or actually to cap the index at a figure below 10 per
cent. The 10 per cent limit clearly aligns the capped index with the capped
rule and allows a more consistent base for arguing the issue with
regulators to seek to create a level playing field.
The downside to this route is that a fund manager will only ever be able
to be in line or underweight. The argument in favour of producing a capped
index at a figure below 10 per cent is that if, for example, the index is
capped at 8 per cent, this still allows active managers to go “overweight”
and, therefore, potentially out-perform the index.
Another option is to try to explain this structural imbalance to advisers,
investors and journalists to drive for change. This could be done in
association with using the capped indices as benchmarks for active UK
equity funds in the meantime.
My concern is that this plays to the index funds as well. The industry has
long sought to explain its apparent failings to investors with excessively
technical language. If active funds underperform passive funds due to this
structural imbalance, then protestations of unfair play in the wider market
will have a hollow ring as active funds are seen to try to explain higher
fees with jargon.
The argument here is not about active versus passive. The model of using
an index core with active satellites for constructing an investor's
portfolio is very powerful. The argument is simply for a level playing
field to prevent anti-compet itive markets and to simplify choice for