Fund Management: Will invest for food

Sir,
In article, Fund Management: Will invest for food, May 3rd, The
Economist highlighted the growth of passive and market tracking
ETFs at the expense of the declining mutual fund industry.
The basis and value proposition of index tracking ETFs is based on
the premise that: the market is efficient; the index replicates the
systematic risk profile of the greater market; a passive tracking fund
is the lowest cost method to replicate the index; and, active fund
management on average cannot achieve returns beyond the indices
[after fees].
It is important to recognise that markets are efficient because of a
large number of similarly motivated participants that can buy (long)
and sell (short) as well as borrow at the risk free rate. If an efficient
market is therefore a product of its participants, it can be deduced
that the cost of an efficient market is the cumulative opportunity
cost of all active protagonists. These costs are typically
management fees that are expected to cover due diligence,
transactional and other operating costs. If index ETFs simply mirror
the efficient market created by active investors than it is no surprise
that low cost ETFs are the most efficient way to get exposure to
systematic risk, and their their AUM will surely grow.
A novel question therefore arises: should passive funds pay royalties
to active managers to use the market they created? Probably not...
Although passive funds, by definition, are not actively managed,
they are market participants and exposed to the exploitation of
inefficiencies and arbitrage opportunities by active protagonists
when they arise.
However, as the AUM of passive funds grow, the index being tracked
will no longer sufficiently represent the systematic risk of the overall
market stocks in the index will become more expensive.
Seemingly, there will be an equilibrium point where active managers
will have sufficient arbitrage opportunities that they will again be
able to outperform the market, to the extent that the fees for doing
so are warranted.
If one were to take a cynical view of Mr Buffetts comments, they
would point out that although he has indeed indicated his trustees
will invest a portion of his estate in low cost market tracking funds,
his fortune is the product of active management. Furthermore, he is
a proponent of Graham and Dodds value investing philosophy,
which is based on the premise of investor irrationality and market
inefficiency the opening paragraph of Berkshire Hathaways annual
report includes a table that highlights the book value of the
companys outperformance of the S&P 500.
In your article, you also overlooked the obvious ethical issue that
the widespread use of ETFs also raises. Since the original public

offering of the Dutch East India Company in 1602, the purpose of

equity and debt markets has been to efficiently allocate capital.
Companies therefore compete for capital allocation based on a
combination of financial and operational factors. If the dominant
source of capital becomes passive that is, allocated on the basis of
rules or quantitative metrics what effect will it have on the motives
of management? Will the S&P become an impenetrable club of
companies that have better access to capital than smaller but more
worthy competitors? Will management be incentivised to therefore
pursue growth at the cost of shareholder value? Will the
representation of shareholders by the board and overall corporate
governance no longer be important? A simple look at the difference
in valuation between H-Shares and A-Shares of Chinese companies
suggests that all of these above factors are indeed valuable to
shareholders. Perhaps in your next article, you might focus on the
value active fund managers bring to the markets I expect that the
number will be somewhere between the total fees generated if all
assets were managed through ETFs and active mutual funds.
All said and done, I have advised my retired parents to allocate a
large proportion of their portfolio to several appropriate broad
market ETFs. After all, if you can beat them, join them?