The increased popularity of index-tracking exchange-traded funds (ETFs) is increasing the risk of mis-allocation of capital, according to Rathbones’ head of multi-asset David Coombs. 
Coombs (pictured), lead manager on the Rathbone Strategic Growth and Rathbone Total Return Portfolios, said that passive investing has begun to have a significant impact on the market.
“We have noticed a big change in the participants in the markets in which we invest,” he said. “Ten years ago among the top-10 shareholders in the companies we own, you would not find a Vanguard or BlackRock generally. There would be active managers [only].”
However, the rising popularity of passive funds – which now represent £201bn of the UK asset management industry’s funds under management, or 16.3 per cent, as of April 2019 – has started to affect active management.
Source: Investment Association
“Not only are you seeing passive investors being some of the biggest investors in stocks, we’ve also seen the rise of baskets and specialist ETFs,” Coombs continued.
“And this is really important because it’s created new risks for us to think about and it’s also created opportunities for us active managers.”
The manager said that there are numerous examples of stocks included in baskets where despite a tenuous link to their so-called peers, they are treated the same.
“Aptiv is a company that designs and puts cabling into cars. Entertainment systems? Satnav? They provide the cabling,” added Coombs.
“They don’t care if the car is powered by electric, diesel or chicken manure, they will put the cabling in.”
“And yet, when a car company has a problem or auto sales are down, their stuff gets hit really, really hard and will drop 20 per cent, maybe. Why? Because they are in the auto ETF baskets.”
Indeed, Coombs said that some ETFs will often invest in companies that have an indirect link to a sector, leading to some “dubious stocks” being included.
“You need to know which basket the company you own is held in,” he said. “We need to know that because if it’s over-owned [and there is] a slight disappointment, the wall of money coming out will be that much greater and the price will be that much more volatile.
“But when Aptiv actually does fall 20 per cent – because Peugeot recalled 1 million cars or BMW isn’t selling many because of the trade tariffs – it falls with all those stocks for the wrong reasons, because ETFs are forced sellers.”
With passive funds becoming forced sellers, this introduces a further dynamic to the market, according to Coombs.
“When an ETF has outflows, it has to sell every company in it, it’s a forced seller. So when the markets sold off in Q4, we were buying off ETFs very happily, thank you very much,” he said.
As such, it is important that investors understand these new dynamics and how every stock trades within their portfolio.
“Take Apple, for example. It’s in the tech basket, it’s in a retail basket, it’s in a US basket, it’s in a global equity basket. It goes on and on,” he explained. “You need to know that for the impact it could have on your portfolio.”
Nevertheless, Coombs does make use of the index-tracking products within the Rathbone Strategic Growth Portfolio and Rathbone Total Return Portfolio.
“I use some ETFs to help us manage risk, we see them as a short-term tool rather than as a long-term strategy,” he said.
The Rathbone Strategic Growth and Rathbone Total Return Portfolios – which Coombs runs alongside Will McIntosh Whyte – recently celebrated their 10th anniversary, with the former up by 188.98 per cent and the latter up 72.37 per cent.
Performance of funds since launch
Source: FE Analytics
Both funds have ongoing charges figures (OCFs) of 0.64 per cent.