One of the most significant developments in the investment management field in recent years has been the rise of indexation – reflected by the growing number and popularity of passively managed tracker funds, which aim to match the performance of whatever index is chosen as their target. The usual explanation is that indexation is seen as a relatively solid, long-term way of managing money, especially by pension funds keener on reliability than risk.
Yet it is interesting to delve deeper into just why the UK has followed the US in embracing indexation so warmly. The reasons can be divided between immediate short-term factors, which are relatively easy to spot, and longer-term macroeconomic influences which are less high-profile but are having a fundamental effect on markets the world over.
In terms of the short term, the current scenario has proved spectacularly positive for indexed funds. Active fund managers, beset by market volatility and sensitivities surrounding the timing of their entry and withdrawal from the equity markets, have underperformed to a surprising degree. At the same time, whatever their level of performance, they still have to charge their active management fees.
Clearly, this scenario cannot last forever, and the active managers will have their day again. But these short-term effects have combined with wider, long-term demographic and political factors to help create and maintain the momentum behind the unprecedented shift towards indexation.
On the longer-term side, one factor is the growing commitment of governments the world over – notably in Europe and Asia – to privatise their potentially crippling pensions liabilities. In the UK, governments of both hues have spent the past few years telling us that we can no longer rely on the nanny state to support us through our retirement, and Continental European governments are now singing the same tune. As a result, the general perspective of investment has shifted away from the ‘speculative’ end of the spectrum, and towards long-term growth.
Another factor is the favourable global environment for big companies. The perception that indexed funds do not buy into smaller companies is something of a myth – although it is true that any stock with a capitalisation of less than £50m (e75m) is likely to drop below the radar. But indexed funds, by their nature, do stand to benefit particularly strongly from a good performance by the big multinational blue-chip stocks, which is precisely what we are now seeing.
The fact is that a wide range of developments in the world economy, from globalisation to Emu and from deregulation to advances in technology, are tending to favour size and scale. These influences have also helped create a sustained boom in merger and acquisition activity on the global stage, resulting in the delivery of substantial value back to shareholders. This background has created the kind of spectacular share price performance among big companies once more commonly associated with penny shares.
A third factor in favour of indexation is the continuing surge in global investment in equities. In continental Europe, for example, the culture of fund management and equity investment is only just taking off. But the rapidly-growing volumes of savings (much of them for private pension provision) are creating a burgeoning demand for something to invest in – which often means equities, frequently on a cross-border basis. And where is that flood of money likely to find its first home? Probably big companies, and potentially via those indexed funds seen as a more reliable bet for the long term.
As I have said, the current one-way bet towards indexed funds cannot continue forever, and it is inevitable that the pendulum will swing back at some stage towards active fund managers. Once they are outperforming again, nobody will worry too much about their higher charges. But, as I have shown, the rise of indexation goes much deeper than the commonly quoted short-term factors, reflecting fundamental long-term shifts in global economics and politics, all of which still have some way to run.
Barry Holman is director, index funds, at Legal & General Investment Management in London