The crazy compulsions of index funds

Index tracker funds offer investors a cheap way to mirror the performance of a stock market index. But they expose you to stocks at exactly the wrong time - when they are no longer good value. Tom Bulford explains why, and what the alternatives are.

Imagine this: you are strapped into your seat, the aeroplane is taxiing along the runway and you hear this announcement:

"Ladies and gentlemen. In order to keep costs as low as possible this plane has no pilot. Instead it will be flown by a computer. As an additional efficiency measure we have eliminated the expensive process of checking baggage. In consequence this plane may contain baggage that is toxic or explosive."

"We hope you enjoy the flight."

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I don't know about you, but at that point I would feign sudden illness and demand to be let off the plane immediately.

But in the dysfunctional world of fund management this exactly describes what happens every day with 'index funds'. Let me explain.

Why I think Glencore is poisonous

Last week Glencore finally became a business quoted on the London Stock Exchange. I don't think I can remember a new entrant that has attracted such controversy.

Glencore acts as a middleman in the world's commodity markets, matching supply with demand, arranging delivery and taking a margin in between.

But in its potted history, Glencore has been accused of supporting mines that poison children; of lending support to brutal third world dictators; of compulsive secrecy and manipulating the world's commodity markets in order to line the pockets of its directors and employees.

And any company that needs a 1,637-word prospectus to describe what it does is simply too complex. I also don't like the fact that Glencore seems to have employed just about every adviser in the City to get this issue away. Twenty three investment banks have managed to elbow their way into the deal, creaming off $275m in fees.

Will any of these investment banks dare to say anything negative about Glencore? I think not. So there will be precious little objective, unbiased advice from the City.

The reason that Glencore has gone public is, as far I can see, to enable its founders to turn some of their stake in the business into cash.

Whether they think that commodity markets are at a peak and that they will never get a better chance to do so, I don't know. But what I look for in a new stock market company is one that genuinely needs stock market finance in order to execute a well-defined business plan. I do not see that here.

But none of that will matter to index funds. The idea with these is to provide retail investors with a cheap way to simply track the performance of, say the FTSE 100, or the highest paying dividend stocks in the FTSE 350.

Some of these tracker funds will buy every stock in the index, copying the weightings exactly. Others use 'sampling' they buy the biggest stocks in each sector, then a sample of the others.

Glencore has a market capitalisation of £36bn. And that makes it an immediate candidate for tracker funds. Like our plane on autopilot, tracker funds are run by computers with the sole task of buying whatever shares happen to be in the index that they track.

Index funds get overloaded at exactly the wrong time

Take the FTSE 100 Share Index tracker fund. If you bought this fund you are now a shareholder not only of Glencore, but also of the barely less obscure foreign natural resource companies Kazakhmys, Petrofac, Vedanta Resources, Antofagasta, Anglo American, Essar Energy and Fresnillo. More than one-third of your money is now exposed to the global commodity cycle.

Maybe you are happy with that and think that the commodity bull still has legs. But consider this. How much nicer it would have been had the index had a generous exposure to this sector before it embarked upon its bull run?

When natural resources were at their low point, the index had no exposure to the sector whatsoever. And you can be absolutely certain because this is the way that index funds work that the index will have its highest ever exposure to the sector at its very peak and when it is poised to go into decline.

Because index trackers invest purely on the basis of size, they have an inbuilt mechanism that guarantees that they have maximum exposure to a sector or to an individual share at its peak; and a minimal exposure at the bottom.

I don't know whether investors into FTSE 100 tracker funds think they are getting a broad exposure to UK plc or global business or what. But in fact, their money is travelling on a plane that will carry any old baggage so long as it is big enough an investment criterion that in my view, virtually guarantees moderate returns.

I would not touch tracker funds any more than I would touch Glencore. What I like are businesses that are simple to understand, that can demonstrate how they make their money and can articulate a credible strategy for growth. That is why I stick to direct investment into small companies.

How to get there before the trackers

We've looked at quite a few exciting junior mining prospects in recent months. I mentioned the rush to secure a share of Africa's $312trn of natural resources. And a few who are "elephant hunting" in Saudi Arabia and Kurdistan.

If you missed these stories the first time around, I have put together a report: "How to pick the perfect junior mining shares in 2011".

You can download it for free here. The password is mining

This article was first published in Tom Bulford's twice-weekly small-cap investment email The Penny Sleuth.

Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund. Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.

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