Market response to Brexit demonstrates why cheap passive funds aren’t good value for the economy

The volatility and volume of trading in the global market response to the surprise result of the Brexit vote on Friday is an excellent example of why cheap passive funds are not good value for the economy, or the markets.

The crashing market, provoked by the panic of what the vote result might mean, was exacerbated by passive funds scrabbling to meet their investment mandate, which is to replicate particular indices.

Passive investment managers aim to create a portfolio of stocks that replicates the performance of a nominated index, such as the S&P/ASX 200, the FTSE 100 or the S&P 500. Their investment decisions and trading activity only reflect changes to the index, not a considered investment decision by an investment professional. There is no consideration of what each company is doing and the economic value they are creating for shareholders, rather the trading is focused on responding to what other investors are doing.

This trend also reflects the rise of the importance of trading over investing. The desire for the quick return, matched with the short-term quarterly reporting culture rewards the buying and selling of assets rather than investing in companies that will produce longer-term growth.

The funds merely replicate an index, which is just a collection of companies that are acknowledged by size, rather than quality. And trading in and out of them is based on a logarithm that is adjusts to continually reflect the market, which moves based on other people’s decision making. It is not based on an assessment of the future growth of the company, the quality of the management and the value the company adds to the economy.

The rise of the passive fund management industry reflects the belief of quantitative analysis as a ‘cost-effective’ way to invest and not have your returns eaten away by asset management fees.

Indeed one of the great active management houses, Fidelity Investments, has decided to start offering passive funds on third party platforms in response to customer demand.

The Financial Times reported recently that passive funds have risen to have $US6bn, up 230 per cent since 2007 and growing at four times the rate of active fund management, according to Morningstar. The focus of passive investing is on the cost of the investment, rather than the value of the investment. Indeed, the marketing of passive funds has focused on the cheapest of the option to invest in a market, because over the long-term equity markets rise.

Active investors haven’t helped themselves with eye-watering fee structures for often ordinary performance. The ‘long-only’ funds, which are allegedly designed for fund managers to buy and hold equities they believe will grow over the long term, have vast pockets of mediocre performance, sometimes due to mediocre managers, sometimes risk parameters that make it nigh on impossible to produce a decent return and sometimes because the fee structure rewards average performance and robs the end investor.

Hedge fund managers, who market themselves as superior to long-only traders because they also bet against stocks they think will fall, leech about half of pre- fee returns  but very often produce mediocre returns as well.

Passive funds do not participate in corporate governance discussions, they do not add to the public debate about company decisions nor do they invest on the basis of good company management decision making. They may be cheap, but they add no value. Indeed, as the events of the past few days have shown they add to the problem.

Active managers need to be less greedy and prove how they can add the value that company management so desperately needs.

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