Outlook: Index tracking

ONE OF the most worrying stock market trends is the rise and rise of the index-tracker funds. There was another survey published this week, showing both that they are continuing to grow as a proportion of managed funds, and that they are continuing to outperform others. Everyone in the City knows it is wrong, everyone knows it is insane, but there seems to be nothing anyone can do to stop it. Like doomsday machines, the trackers keep coming, vacuuming up all before them.

The tracker fund's raison d'etre is logical, practical and compelling. Because no one, however inspired an investor they are, can hope indefinitely to keep spotting the market winners, it is best to spread your bets across the market as a whole.

Over the last two to three years, for instance, the hot sectors have been banks, telecommunications, pharmaceuticals and anything to do with computers. If you had had the foresight to invest in only those sectors, you would have done amazingly well. Unfortunately, since all these sectors looked relatively expensive even three years ago, very few investors will be in that position.

If on the other hand you had invested only in other sectors, you would have done amazingly badly. In these circumstances it is hardly surprising that investors should wish to spread their risk. To the despair of "active" fund managers - those that sell themselves on the basis of stock selection - trackers have consistently outperformed during the great bull market of recent history.

So much so, that trackers are now the Government's and the Office of Fair Trading's officially recommended investment vehicles. Why pay useless fund managers over the odds for underperformance when low-cost passive investment so consistently beats them, the Office of Fair Trading asked in a report last year.

It is hard to argue with the point. Nonetheless, the investment effect is a perverse and dangerous one. What it means is that the biggest and most favoured stocks attract money in ever-increasing amounts, regardless of the underlying fundamentals, which in turn means less money for the rest.

Take the two recent transatlantic mergers in the FTSE 100 - BP and Amoco, and Vodafone and AirTouch. British tracking investors were forced greatly to increase their weighting to these companies after the mergers went through, so as to take account of their much greater market capitalisations and their consequent relative position in the market as a whole.

Obviously that means less capital for other companies. But it is worse than this; the more Vodafone shares rise, the more Vodafone shares the trackers have to buy, making them more valuable still. Many trackers are being forced to invest in a way that few of their professional managers would think sensible or advantageous. Some of the more candid ones say it openly - "I wouldn't buy shares at the valuations my tracker funds do". What we have here is not so much a speculative bubble, for that description implies choice, as an enforced one.

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