Alan Steel: Don’t need time machine to see folly of tracking stock market indexes

Wouldn’t it be handy if investors had easy access to a time machine. Not one that looked back, but one that could look years into the future.

What a bonus that would have been 30 years ago. Does anybody remember how we all felt back then about our economic prospects? Times were tough: UK interest rates were in the high teens so mortgage rates were crippling. We had just survived a recession, the stock market hadn’t gone anywhere since 1965 and unemployment had reached a record high, with three million jobless.

Even after three years of a Conservative government the top rate of tax was 60 per cent, rising to 75 per cent if you also had significant investment income. Unfairly a wife’s unearned income was taxed as her husband’s.

It wasn’t a good time to be a high earner with a big mortgage (despite tax relief), or an investor saving for retirement. It looked fine if you were retired, earning interest from banks or building societies (if you ignored tax and inflation).

Mainly, things didn’t look good. But now, looking back, you couldn’t have been more wrong. It was a time of opportunity. The doom-mongers didn’t see it at the time, but interest rates could only have gone one way – down. Stock markets had been so poor since 1965 that even the law of averages suggested they could only get better.

As it happens, anybody taking the time to study history would have seen what was going to happen next. Because, when you study history, you can see trends and cycles.

Most folks like to think progress is linear, but in fact it’s cyclical. Pity somebody didn’t tell Gordon Brown. Recognise where you are in long or short cycles and, as my dad used to say, “you’re quids in”.

Looking back, 1982 was a pivotal year. A new long-term bull market started in equities, much to the surprise of economic doom sayers. A new bull market began in gilts too. If interest rates were likely to fall, locking into 17 per cent returns wasn’t a bad idea, especially as you could sell the asset some years later at vast tax-free profit.

Roughly half way between then and now the number crunchers, including mathematicians and actuaries, seeing what had happened over the previous 15 years, and assuming this was likely to last forever, built their models.

They had this idea of the efficiency of markets and for equity investment came up with “what could be simpler than just following a stock market index?” After all, if an index keeps going up, why bother trying to do too much work spotting individual winners?

So, in the UK, index trackers were born, and sadly still dominate equity exposure in most final-salary pension schemes. Some 15 years later these very pension schemes are in trouble. Can you spot the link?

Indexing worked just fine for the first four or five years, but then something changed.

You didn’t need a time machine to spot it. All you needed was to study history. Do that and you’ll notice these long-term cycle changes – referred to as secular changes.

Should you index track when in a secular bear market? Between December 1999 and March 2003 the FTSE 100 Index fell 52 per cent. From the Summer of 2007 to March 2009 it fell 48 per cent. Why track an index that can fall 50 per cent in less than two years?

So, still without a time machine, what does history tell us is likely to happen over the next five to ten years? Well, sadly, it suggests that the UK stock market index will still resemble a financial yo-yo. That’s not good for our nerves.

As for gilts, we’re likely to see a secular change – a 20- to 30-year period where interest rates move upwards. That’s bad news for gilt holders today.

So, unless investors change their ways – especially trustees of final-salary pension schemes and their advisers – it looks like there’s more misery going to be piled on. But it’s good news for those who follow the best active managers, and fortunately there’s a good few of them.

• Alan Steel is chairman of Alan Steel Asset Management