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FIVE YEARS ago a New York Times blog ran the headline: 'The debate keeps going'. It referred to the argument over passive versus active investment. It's still going.

The main difference seems to be that the contest involves more heavyweights in each corner.

They don't come much heavier than the British Government's Department for Communities and Local Government, for it has suggested up to PS85bn of defined benefit pension fund assets managed for local authorities could be moved from active to passive management.

This prompted Neil Walton, Shroders' head of the UK institutional business development group, and his colleague in UK strategic solutions, Alistair Jones, to look closer. The result was a paper called The Hidden Risks of Going Passive.

What prompts investors to look at passive systems, of course, is average returns from actively managed funds frequently fail to justify their higher fees. Frankly I don't blame them. At least one part of this paper, though, bears sharing. It is that passive indices can contain "unwelcome biases and hidden concentration risks".

Traditional equity indices weight their constituents by market capitalisation. Bigger companies dominate. For example, at the start of this financial year, three quarters of the value of one widely used benchmark, the MSCI World Index, came from large-cap stocks valued at more than US$20bn.

Investors are "buying into yesterday's winners," say the authors. They performed well historically but are now prone to underperform as smaller stocks erode their market dominance.

The effect of the weighting can be to force purchases of expensively-valued shares and sales of cheap ones. An index without this weighting, such as the MSCI World Equally Weighted Index, has outperformed it since 2001.

The size-weighted index may also be biased towards low-quality stocks when measured by stability of earnings growth. Another problem is a lack of breadth. "An index-bound investor unnecessarily restricts their investment choices," writes Jones. "For instance, while the MSCI World Index is currently composed of over 1,600 stocks, we calculate the universe of global stocks with sufficient investable liquidity comes to more than 15,000."

He points to periods when the problem of concentration can be compounded. "In February 1989, 44 per cent of the MSCI World was composed of Japanese stocks as a bubble formed in Japanese asset prices. In February 2000 tech and telecoms stocks made up over 35 per cent of the same index." Both sectors subsequently underperformed badly.

Even in February this year, three of the four largest stocks in the index were IT firms: Apple, Google and Microsoft. In the UK, the top 10 stocks made up 36 per cent of the FTSE All-Share Index at the end of 2013 with Vodafone weighing in at 5.5 per cent. Established tech and telecoms firms can suddenly underperform when overtaken by rivals.

My conclusion is that no investor should be passive; finding the right indices to follow requires active selection. ?

Traditional equity indices weight their constituents by market capitalisation. Bigger companies dominate

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Title Annotation:Features
Publication:Insider Monthly
Geographic Code:4EUUK
Date:Aug 5, 2014
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