My banker friend’s mistake

I would sooner rugby-tackle my mother than buy a fund. All indexed funds suffer from one basic problem. They are backward looking.

I have been skiing in France, where one of my companions was a highly intelligent man who had enjoyed a successful career as an investment banker. When I told him that the only aspect of City life that ever attracted me was the stock market he replied that it held no interest for him whatsoever and that he parked his savings in Indexed Funds. He reasoned that the majority of actively managed funds underperform index funds and yet charge higher fees, both of which are true.

Don’t be fooled by index funds

Now as you may have noticed the FTSE 100 share has just achieved the abject distinction of reaching the exact same level that it hit nine years ago. I accept that this does not include the dividend income and furthermore that there are plenty more interesting indices to track than the FTSE 100. But all indexed funds suffer from one basic problem. They are backward looking.

Typically indices are compiled on the basis of market capitalisation, so companies enter them only once they have attained a certain size. This has two consequences. First there are certain very large industries where economies of scale matter. For this reason the FTSE 100 index is still top heavy with banks and oil companies, in spite of their obvious problems.

The other issue is one of cyclicality. Back in about 2000 when I was still working in the City, few fund managers had any holdings of mining stocks. Even companies like RTZ and BHP were too small to bother with.

Then came the great China-driven commodity boom. Suddenly mining companies became very highly valued and started appearing in market capitalisation-based indices. The FTSE was graced with some highly dodgy names like Glencore, Eurasian Natural Resources and EVRAZ so that at the peak of the mining boom 15% of the FTSE Indexed fund’s investors’ money was in this sector – just in time for the inevitable cyclical downswing.

In this respect index funds (including those tracking the NASDAQ Biotechnology Index) do the very opposite of the sensible investor. Rather than taking some profits on the upswing they just get in even deeper. And rather than looking to overweight companies that might grow large in the future they choose those that have already done so.

Depriving docile investors

Along with hedge funds, split-capital trusts and other inventions of the great financial services marketing machine indexed funds will eventually be seen as just another vehicle to deprive docile investors of the great returns that stock market investment can offer.

I have two abiding principles. I would sooner rugby-tackle my mother than buy a fund, so I invest directly into quoted companies.

And I look forward and not back. The really pitiful thing about the performance of the FTSE index over the last decade is that, contrary to what its investors probably think, it comes nowhere close to capturing the development of the UK economy.

I use the word ‘development’ rather than ‘growth’ because although the UK economy has grown over the past decade some sectors, like mobile communications and online retailing, have done massively better than the sluggards (like the banks and oils that I mentioned earlier).

We need to find the industries that are going to prosper in the future. I am convinced that biotechnology heads the list and the more I learn the more convinced I become.

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