Should you follow the dumb money into passive investing?

The popularity of passive investing has had an unforeseen effect on stockmarkets, says Sarah Moore. That's left room for smart investors to profit.

"Fifty years ago, indices were simply averages produced by newspapers and academics using slide rules, to help gauge the general direction of the market," writes John Authers in the Financial Times. Now indexing is a multi-million-pound industry a company such as S&P Dow Jones calculates more than a million indices a day. And the amount of money being invested based on these indices is having an increasing impact on market behaviour, reckon some experts.

It's all down to the rise of 'passive' investing. Passive funds aim simply to track an underlying index rather than beat it, as 'active' managers do. They've become popular for two main, related reasons: firstly, despite their stated aims, most active managers fail to beat their index over the long run. Secondly, active managers charge for this underperformance, whereas a passive fund is essentially run by a computer, which is a lot less expensive. So buying a cheap passive fund that will more than likely beat an active manager makes sense to an increasing number of investors.

As a result, although they've only been around for 25 years (and been widely accessible for private investors for less time than that), exchange-traded tracker funds (ETFs) already hold around $3trn in assets around the world more than is invested in hedge funds, according to researcher ETFGI and that volume is expected to double by 2020, one of the reasons that investment banking giant Goldman Sachs has just entered the market with its own range. But what does this increasing dependence on money that is simply "dumbly" tracking an index mean for the markets?

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Paul Woolley, head of the London School of Economics' Centre for the Study of Capital Market Dysfunctionality, argues that all this passive money contributes to bubbles being inflated, because "the more a company's price grows, the more index-trackers will be required to buy of it". In other words, a traditional passive approach is essentially "buying high, sellling low" which is the opposite of what most investors would aim to do.

Meanwhile, Simon Laing, head of US equities at Invesco Perpetual, warned this month that the money flooding in and out of ETFs every day means markets are "more driven by the flows of hedge fund and retail money than by views about the fundamental worth of companies". That could well help contribute to more volatility and "flash crashes" such as last month's dive in the S&P 500, which saw big stocks such as Pfizer and Apple plunge dramatically for no obvious reason.

These are valid concerns, but it doesn't mean you should be making a wholesale switch back to active funds. For one, global markets haven't been taken over by passive money yet. There's still a lot more in active funds around $16trn in the US alone, according to Bloomberg. Authers also argues that while indexing harms market efficiency, it provides opportunities for investors who can exploit sectors with low levels of passive ownership (see below), or can predict how the market will react to changes in index composition.

For example, FTSE Russell indices change composition once a year (one day in June), typically the biggest trading day of the year in America. In other words, the more 'dumb' money is in the market, the easier it should become for smart active investors to profit from it.

Fund managers are also turning to 'smart beta'. These funds don't just track indices, but are based on strategies that should be more profitable in the long run, such as value investing. But while some are worth considering, they also tend to be more expensive. And this is the key issue your costs are the only thing you have any real control over. It's the one key area where passive funds still have a big advantage.

The sectors to buy and those to avoid

So if you want to beat the market, reckons Deutsche Bank strategist Sebastian Mercado, you should be looking to buy stocks in sectors with lowlevels of passive ownership. According to Mercado, investors looking to beat the market would do well to avoid property, utilities, materials and energy, all sectors that feature prominently in ETFs the real estate sector is the worst, with an average of nearly 20% passive ownership per stock in the sector.

Financial services, technology and health-care are likely to be happier hunting grounds for stock-pickers who fancy their chances of winning big, with far lower levels of passive ownership.

Sarah is MoneyWeek's investment editor. She graduated from the University of Southampton with a BA in English and History, before going on to complete a graduate diploma in law at the College of Law in Guildford. She joined MoneyWeek in 2014 and writes on funds, personal finance, pensions and property.