Expert View: Will the torpedoes sink index funds?

Fund managers know some stocks as "torpedoes". These are the ideas that don't just go wrong, they explode, leaving gaping holes in your portfolio where once was wealth.

Fund managers know some stocks as "torpedoes". These are the ideas that don't just go wrong, they explode, leaving gaping holes in your portfolio where once was wealth. There is no shortage of these at present, with even blue chip names defying your worst nightmares. The likes of Cable & Wireless and Marconi have created a feeling that you just don't know where the next hole will appear below the water line.

For the small investor this is leading not so much to a re-appreciation of investment risk, as to sheer panic. A whole generation of investors is turning from stock markets to rental property, or simply clinging to its cash. But the reaction among large institutions is different. Now is the moment for professional investors to prove themselves by spotting the bottom. Many are actually thinking of taking more risk, and there is a renewed emphasis on stock picking. One interesting question this begs is what the effect will be on passive funds, the trackers that simply replicate the stock market index, thus eliminating stock risk and opportunity. These funds have enjoyed monumental growth; is that about to change?

When the first serious index trackers were set up on Wall Street in the 1950s, they were slow to catch on; who would simply want to track the market when there was the opportunity to outperform? The 1980s bull market changed all this; the easy pickings of ever higher stock prices combined with many fund manager failings to make them the height of fashion. A large proportion of global wealth – and an estimated 30 per cent of the UK pension market's savings – is now held in mammoth index funds.

It therefore took many by surprise when one of the giants in the UK pensions market, Legal & General, announced last week that it was to return to active investment management and set up a stock picking team. What is going on?

"A flood on the Yangtze sinks all the boats" was a common saying in the Shanghai market in the 1930s. This bear market has rudely brought home to pension funds that they are in danger of not matching liabilities. In constantly rising markets, you might as well just take the low-cost option and buy everything, in a tracker. But in the tough times we live in, other asset allocation strategies (eg bonds, property) or indeed other, new investment approaches, such as derivative-based or hedge fund products, are dancing round the feet of the index dinosaurs.

Even before the flood, these giants were being wrong-footed. Corporate financiers have long exploited the slavish replication of the index when it came to corporate restructurings or new issues. The automatic purchases made by passive funds were in danger of making them something of a soft touch.

Equally, the trend towards exacting corporate governance has been massively boosted post-Enron. Two classic American assumptions (that you just left board management to get on with it, and that it was only the shareholders' interests that mattered) are looking out of date. Every fund manager and his dog now have corporate governance departments, with (highly paid) investment professionals devoted to watching management. Where does this leave passive funds that have built a business on low-margin investment not requiring expensive stock pickers?

I have to declare an interest. I am a dedicated active stock picker myself, so I take comfort in these trends. It's not much fun in the City at present, what with all those torpedoes and the weekly lay-offs. This at least is one area of hope. While the small investor is turning to his piggy bank, large investors are getting more daring and more innovative. At this our darkest hour, maybe the fun is about to return to investing.