Mark Lister, 16 November 2017

Index funds are all the rage at the moment. As interest in passive investing continues to grow, the debate over their place in the investment landscape gets more heated.

Their proponents sing the praises of taking a passive approach, while the traditional fund managers get defensive at the assertion their high fees aren’t justified. Others worry about the impact of index funds on share prices and market valuations, and I even heard someone blame them for Xero leaving the NZX.

I like index funds. They can be very useful, especially for international shares where you want to get exposure to a theme, sector or region.

Want to buy the German market but not the rest of Europe? There’s an index fund for that. Want to play the US tech sector but can’t decide which three stocks are best to buy? No problem, buy the tech index fund and own a piece of all of them.

Still, I can’t help but feel like they are getting a bit of a free ride at the expense of other people in the industry.

Don’t get me wrong, I see the appeal of passive investment. Index funds are easy to understand, they give you instant diversification, and they’re dirt cheap in terms of the fees they charge.

However, I can’t see how index funds can exist without the traditional parts of the industry also taking a significant role. Those parts include the active fund managers, the brokers and analysts that compete for their business, and the private investors and their advisers.

Passive funds just buy whatever is deemed to be in the index, which is a function of many factors including size, liquidity, share price and so forth.

A lot of those things, particularly share prices, are heavily influenced by what the active managers are thinking and doing. They’re constantly trying to get an edge over the competition, in the hope of squeezing a better performance out of their fund each month.

Then you have the broker analysts, scrutinising every minor detail of each company, looking for something the others have missed to provide the most useful insights to their clients.

All of those people are well paid for doing very specialised jobs, which ultimately means higher fees for their customers. We all hate fees, and minimising costs is one of the best things you can do to maximise your long-term investment returns.

Nonetheless, if these industry experts didn’t exist how could we be confident share prices broadly reflect the prospects and outlook for each company? And who would be holding the companies to account, dissecting their every move and questioning each decision? Not the index fund providers, that’s for sure.

The passive investment industry needs their active competitors. If nobody was doing the work of the fund managers, broker analysts and more sophisticated wealth advisers, things would all be a bit haphazard.

Similarly, the rise of index funds is keeping the active fund managers on their toes. There’s more pressure to perform and offer a quality product when there’s a cheap, highly efficient alternative waiting in the wings to happily steal your business.