A radical technological change over the next 10 years will “rip apart” broad market indices, according to Neptune chief economist and chief investment officer James Dowey, who warns that investors who are “tied to indices” via trackers will be hurt badly as some of the market’s most established firms will all but disappear due to these developments.
There has been a huge surge in popularity in passively managed funds over recent years thanks to changes within the industry such as a greater focus on costs, as the likes of tracker funds and ETFs tend to charge far less than their active rivals.
Tracker enthusiasts also point out that mirroring the index has been fruitful strategy over the long term as you remove the human risk from a portfolio.
There is also little doubt that, as a homogenous group, active funds have failed to add significant value against the index over the longer term as while there have been those which have massively outperformed, there have been just as many which have consistently underperformed.
This is shown by the performance of the IA UK All Companies sector average since January 1990, as, while not a like-for-like comparison, it has underperformed the FTSE All Share by some 90 percentage points over that time.
Performance of sector versus index since Jan 1990
Source: FE Analytics
However, Dowey thinks this trend is going to reverse in a big way over the coming 10 years. 
“One theme we think will dominate markets is something we call ‘tech risk’. We think that technological change is going to be extremely rapid for a number of reasons over the next decade from a historical context,” Dowey (pictured) said.
“I think it is going to completely befuddle everybody and I don’t think the impact it will have on markets is going to be great – in fact I think it is going to be very mixed and I think active management is going to be essential in terms of delivering even decent returns over the next 10 years.”
The chief economist points out that there are plenty of macroeconomic headwinds facing investors, one of which will be a rising interest rate environment.
For example, he says the fact monetary policy has generally become looser and looser over the past 30 years has meant it “has been very easy to look like a hero” in most asset classes and therefore a change in dynamics will cause problems for investors.
However, he says this tech risk will “dwarf” these headwinds.
“I actually don’t think that macro is going to be that important over the next decade because I think the issues regarding tech are going to much more influential. I think this [tech risk] going to dwarf the day-to-day, year-to-year macro developments. China’s had a wobble. Who cares in the grander scheme of things?”
“I’ve spent a lot of my academic work looking at the long sweeps of technological change dating back to the industrial revolution and I think the forces that generated that change in 18th century Britain are at work again today.”
He added: “Essentially, it was access to knowledge. You saw a continuous fall in the price of access to knowledge in 18th century Britain and we are seeing that again today.”
He points that many exponential rules such as Moore’s Law (the fact that the number of transistors have doubled every year), Kryder’s Law (hard disk cost per bit down 50 per cent every 18 months), Hendry’s Law (pixels per dollar up 60 per cent per year) and Butter’s Law (cost of transmitting down 50 per cent every nine months) are all combining and are in a sweetspot. 
He says the impact over the next decade or so is going to be a radical disruption across the economy and across differing industries such as healthcare, finance, transportation, energy and manufacturing.
Dowey added: “As a result of this, I think you are going to see established businesses that you and I both know and love (or even take for granted) have their business model ripped apart over the next decade.”
“Hence, I think this is going to be a hugely difficult time for the stock market and the aggregate index. I think large parts of it, to all intents and purposes, won’t exist in 10 years’ time and if it is it will be limping along in a zombie-like fashion having had any profitability ripped away from it through challenges to business models.”
Dowey and Neptune have listed 12 key technological disruptions, such as robotics, 3D visualisation, drones, genomics, artificial intelligence and solar energy.
He understands that many people will write off the risks of these technologies, given many of them have been around for a number of years now but have had no major impact. Nevertheless, he says this is a usual trend as, following the initial period of R&D, many of history’s most disruptive technologies have failed to make any in roads for a prolonged period of time.
He says that cars in the early 1900s are a good example, as after initially being seen as a bit of a fad they completely demolished the need for horse and carts over 10-year period.
More cynical readers aren’t likely to be shocked that that the chief investment officer of a group which only provides active funds believes that passively managed vehicles are going to struggle, of course.
On top of that, there is the argument that the UK’s largest and most established companies which make up a large proportion of the index (such as Royal Dutch Shell, GlaxoSmithKline and HSBC) are aware of these changes and are looking to acquire these new technologies to keep ahead of the competition.
Performance of stocks versus index over 20yrs
Source: FE Analytics
However, Dowey says that many of the innovative companies which are creating these technologies don’t want to sell themselves out as they would lose the dynamism to create these incredibly destructive changes.
On top of that, he says large and established firms have a historically poor record of reacting to disruptive technology.
“There is actually a lot of academic literature on why established firms are so bad at adapting to new changes and there is a very profound mechanism at the heart of it. If you become big and successful it’s probably because you are good at what you do, you’re good at providing what your client wants.”
“Valuing what your client wants and making sure you are in the now, so to speak, on your product line is pretty incoherent with focusing on what the next trend is. You don’t want to eat your own market that you have created.”
“On the whole, I think the predominant picture is these guys [the largest constituents of the index] lose out.”
Dowey says that this is a risk that all investors need to pay attention to, as by focusing on market indices many aren’t going to be able to save enough for retirement – especially as the outlook for bonds is so poor.
“It’s this idea that investing across indices broadly and not in an active way is just not going to do it for you over the next decade – your expected returns are going to be low and the raising interest rate environment is not going to help whatsoever.”
Of course, the major task for investors (if Dowey’s predictions do prove to be correct) will be to find the active managers that can keep ahead of the curve by focusing on these changes and beating the index as a result.
