The perils of index hugging

Gervais Williams, managing director of MAM Funds, considers the industry’s increasingly-worrying obsession with indices and asks if this is the best way to service our clients’ needs.

January is a time of resolutions. We seek to address some of our bad habits, and become just a little more virtuous. But sometimes our greatest problem is in the recognition of the worst of our bad habits. One that I worry about is our unhealthy reliance upon investment indices.

They seem so innocuous. Most clients feel that indices are their friend. After all, indices act as a Darwinian force, a yardstick to highlight the effectiveness or otherwise of the fund manager, and ultimately eliminating the less able.

They also help classify the universe of companies within which a particular fund invests, and therefore enable portfolios of funds to be stitched together with clear delineations between them. Most professional fund managers would argue that investors would be less well served without indices.

Whilst I accept there is a place for indices, my bugbear is that we as an industry have become too dependent upon them. A spoonful of sugar may help the medicine go down, but a diet of sweets rots teeth or worse.

Blind

It is not that I object to most conventional funds having a clearly defined benchmark index. The problem lies in the fund manager’s unhealthy focus on all things within the index, and their near blindness to anything outside this tightly defined playground.

Within indices, it is those sectors which have benefited most from the past trends that represent the largest weightings. Large index weightings steer larger parts of our client’s funds specifically into those businesses that subsequently peak out, thereby lowering investment returns.

The classic example was the growth of the weightings of banks in the FTSE 100. By December 2007, they represented 18% of the overall index. Yet with the global financial crisis many of these stocks not only suspended their dividends, but also fell back precipitously, demanding additional capital on the way down.

Spare a thought for those clients unlucky enough to be located in Ireland, where the banks sector grew to become 46% of the Irish Stock Exchange Index in February 2007. The ISEQ has fallen from an index value of 10000 in February 2007 to just 2900 now mainly for this reason.

Equally, conventional indices have little regard to stock specific risk. The largest weighting is typically a supersized business tussling with the law of large numbers; the bigger you are, the more improbable the chance of doubling.