The boom in ETFs is good for active managers

The stampede into index funds and ETFs has set up favourable conditions for active managers. Not perhaps for the biggest index-hugging institutions, but positive for fundamentally-based investors that take active risk. 

Passives are currently growing, but may actually be dinosaurs. Momentum buying of mega-cap stocks might be a low risk approach in a stagnant world without competition, where brand and business scale can create huge entry barriers, but we live in a world with increasing disruption that challenges incumbents. The forces are not just technology, big data and new business models, but changing consumer tastes, as millennials shun old brands and favour experiences over goods. 

Fevertree Drinks, for example, has created a powerful brand and a £2.5bn company in just a few years within a cosy sector dominated by giants. Other brands are fading. In 2017 Heinz saw a collapse in sales of its soups, beans and ketchup. Company lifespans are indeed shortening. Of 81 companies that joined the Fortune 500 between 1955 and 1960, just 7 are left today. If anything, that change seems to be accelerating. 

Passive funds certainly offer lower costs. Given the pressure on wealth managers and financial advisers, it’s easy to understand the trend to increase client allocations to index funds. It seems consensual and cheaper. But, disruption is challenging the argument that the biggest companies just keep on growing, or are even safer. 

Essentially, the indices are backward looking, capturing past strengths that historically drove the dominance of today’s big businesses. In years past there may have been safety in brands and blue-chips, but no longer. As several FTSE 100 companies have already shown – think Provident Financial, Dixons (Carphone Warehouse) and Kingfisher – the world is changing. The pace seems to be catching incumbent businesses and the market by surprise.

-10 shares to give you a £10,000 annual income in 2018

Those sceptical about active investment should check the data. The Investment Association UK All Companies sector comprises 252 funds. It may not be statistically significant that the median manager in that sector is ahead of the FTSE All-Share total return for 2017. But outperformance by the majority of funds is also evident in the data for 3, 4, 5 years and longer. This persistence of outperformance is hard to dismiss, and we need to recognise opportunity and skill when the facts are so clear. 

The bargains are hiding further down the FTSE 100, in the Mid 250, and in some larger AIM stocks. Not only has the Mid 250 beaten the FTSE 100 over the last 5 years, but it is also ahead since records began more than 30 years ago. It seems the quality blue-chips driven by the momentum of index investing are not always the best place to be. There are more dynamic and mispriced businesses out of the spotlight. 

And, the concentration of the FTSE 100 Index in a few large companies dominated by a handful of sectors is worrying. Just 28 FTSE 100 companies, in a handful of industry groups, represent more than half the Index. Will sectors such as energy, banks and materials play as big an economic role in future? Is passive momentum investing wise; buying more of a company, the more inflated its valuation?

Surprisingly, the risk/return statistics are also favourable for the FTSE 250 versus the FTSE 100. Of course, there will be times when fundamental analysis shows the valuation opportunity in a big company. Active management and an unconstrained approach offers the flexibility to move money in and out of major companies as market conditions change. 

The problem for some of the biggest funds is that even stocks at £2bn capitalisation can be hard to access. And many of these companies have little need for new capital raising, denying an easy entry point. We believe there is no need to hug the index or worry about passive funds. In UK All Companies at least, active investing is confounding the sceptics.

Colin McLean is managing director at SVM Asset Management.

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