Indexed funds make a popular choice for small investors
Last week's explanation of how a company's share price takes a substantial fall because it has lost its place in a widely used share index generated several questions from readers wanting to know more.
The reason this can, and frequently does, happen is the growing popularity of investing in passive indexed funds instead of actively managed funds. The basic argument for investing in indexed rather than actively managed funds is a significant reduction in costs and uncertainty about the additional investment returns provided by active managers.
Put simply, unless the active managers can consistently outperform the movement of share indices, there is little point in paying the higher fees they charge. The popularity of investing in index funds has increased over recent years through the introduction of lowcost exchange traded funds traded on the Australian Stock Exchange. These ETFs invest in the shares covered in a specified sharemarket index, usually but not always using the same percentage weighting the companies have in that index.
Before the introduction of ETFs, unlisted managed funds investing in specified market indices were the main vehicle for indexed fund investing. For small investors, including DIY super funds, there are attractions to owning listed ETFs rather than managed funds because of the greater liquidity. These recent trends in share investing highlight the importance of companies obtaining and maintaining their place in the key share indices.
The operating rules for passive indexed funds are rigid. They force the disposal of shares no longer in, or losing their weighting in, the index and also necessitate the purchase of new companies entering the index or increasing their weighting in it. This is an automatic process based on a version of survival of the fittest.
When a company's share price is falling, causing the removal of the shares from or a reduction in its weighting in the index, index funds and ETFs have to sell the shares, which adds to the downward pressure on the share price. Similarly, when the share price is rising and the weighting in the index is increasing, the funds and ETFs have to increase their holdings, adding to the upward pressure on the share price.
These price variations might be in the best interests of investors if the reason for the share price movement is fundamental to the change in the value of the company concerned. But with markets able to be manipulated by short selling and genuine misunderstanding of the value of an individual company, changing share prices are not necessarily an accurate guide to a company's prospects. This is why, for reasons to be outlined next week, I consider it essential to limit short selling to shares in the top 50 or 100 companies.