How central banks created the bubble in passive investing

Central bankers’ rock-bottom interest rates have encouraged passive investing

GERMANY-BADEN-BADEN-G20 MEETING

Central bankers have created many weird distortions in financial markets in the last decade or so.

Negative interest rates. Countries being able to charge institutions to lend them money. House prices that have grown beyond any rational person's ability to comprehend.

But one of the most interesting distortions – and the one that could be good news in the long term, but could also trigger a very painful correction in the short term – is the popularity of passive investing...

Passive investing is great – but investors are very adept at breaking things Vanguard's Jack Bogle should give thanks to the world's central bankers every morning. Maybe he does. They're one of the main factors that has turned his company into one of the world's biggest asset managers.

Why do I say that? At MoneyWeek, we've been fans of passive investing for years. Passive funds charge low fees and all they promise in return is to track an underlying market. The thing is, that's better than what your typical actively managed open-ended investment company does. Most active funds will charge you a lot, and in return, they'll underperform the market.

Thing is, it's taken a while for people to catch on. Before the financial crisis, only a few "in the know" investors were really interested. When interest rates are up at 5% or 6%, no one cares what they're paying their financial adviser or fund manager. What's 1.5% in a world where your bank account pays 6% and you expect your stocks to pay a lot more?

But then 2008 came. Two things happened. People became more sceptical of the financial industry in general. But more importantly, interest rates collapsed. When rates are at or near 0% every basis point counts, even to your average saver in the street. Suddenly, that 1.5% looks pretty hard to justify. Hence the growing popularity of passive investing.

And now passive investing isn't only for the "smart" money. It's where all of the money is going. And as John Dizard noted in the Financial Times this week, there's a whiff of a mania about it. "We have created a bubble in average... Waiters and childhood friends are no longer telling us about what miracle gold, oil, or tech stocks they bought at the right time. They are exchanging stories about low management fees on their index-tracking exchange traded funds."

Index investment and buying on the dips has "been suppressing short term losses, or corrections". As a result, when the "eventual decline" does come, it'll be "not just painful, but catastrophic".

Dizard doesn't spell out how a crash might happen. But he rightly focuses on the promise of perfect liquidity proffered by exchange-traded funds (ETFs – passive funds that trade on the stock exchange and can be bought and sold from minute to minute) in particular. A big crash could perhaps be self-feeding and potentially some of the ETFs in question might stop tracking the underlying stocks given a sufficiently chaotic collapse.

Now, to be clear, and as I've written before, I am a big fan of passive investing. It makes sense to invest as cheaply as you can. Investors shouldn't be handing over huge sums of money to workers in the financial industry who aren't actually doing anything to earn that money. In the long run, passive investing is a fantastic innovation and it's here to stay.

Equally, however, I'm also well aware that every successful financial technology is always pushed to a breaking point by investors at some point. ETFs might not cause the next crash, but they will almost certainly be involved as a channelling and multiplying mechanism of some sort.

The active funds that can do what they're supposed to

Of course, there's no way of knowing when things might turn down. Otherwise you'd be able to hop into cash, stay there for a bit, then get back out.

However, if you are entirely in ETFs, you could always diversify your portfolio a bit. You could try investing in active funds that actually work. If you find an active manager who's smart enough, then maybe he or she will be able to exploit the "inefficiencies" that should constantly be thrown up by investors blindly pumping money into the biggest stoics on the market.

"But", I hear you say, "didn't you say that active funds are rubbish?"

Most of them are. But handily enough, a good piece by Gavin Lumsden on Citywire earlier this week notes that a certain type of active fund isn't – the good old investment trust.

Lewis Aaron of Fund Consultants looked at the investment trust sector (nearly 400 trusts), and compared its performance with roughly 1,500 exchange-traded funds. He split the funds into different sectors (mainly by country and stock size). And he found that investment trusts did a great job – even taking their higher fees into account.

Over ten years, investment trusts beat the ETFs – in other words, beat their benchmarks – in nine out of ten sectors (where there were ten-year records).

The only sector where they failed to beat the ETFs was in US large-cap equities. Now, I'm not convinced by the efficient market hypothesis – at all – but if one market comes closer than any other to being efficient, it's probably the market for US blue-chips (although come the next crash, we'll see how that stands up).

There are a couple of things to note. Aaron's study was based on net asset value (NAV) – in other words, the value of the underlying portfolio. Investment trusts are listed on the stockmarket, so their share prices do not always trade in line with their NAV – often they trade at a discount (so you can buy the underlying portfolio for 90p in the £1, say), or occasionally, the very popular ones trade at a premium. But once you wrap your head around that, it's not something that would put you off investing in them.

Also, investment trusts are able to borrow money to invest. Clearly, as a group they've done a reasonably decent job of this, or they wouldn't have managed to outperform. But it's another factor to keep an eye on when you're considering what trusts to invest in.

MoneyWeek has been running a model investment portfolio in the magazine since 2012. Subscribers can read the most recent update here (If you're not already a subscriber, sign up now).