I AM told that there is more than one way to skin a cat. I will take it on faith as that kind of pastime holds little appeal for me.

I am also told that there are lots of ways to approach investing in the stock market.

This I do know to be true as I have tried a number of them myself. Most approaches have the dubious advantage of being useful some but not all of the time. Those who put their faith in a magical ability to make predictions based on examining stock price charts with clever technical analytics attached will be familiar with this.

Over recent years thematic investing has become more popular, though it is not a new idea.

For the benefit of the uninitiated, providers such as S&P or MSCI launch an index based on a certain theme, say mining or artificial intelligence or the FTSE 100.

It is hoped that these indices will attract providers of Exchange Traded Funds (ETFs) who will licence these indices and replicate them with a new ETF.

In addition, asset managers often launch their own funds that are based more on active management and fundamental analysis, rather than the passivity of ETFs.

The most widely adopted theme over recent years has been the rise of ESG funds. This is despite the fact that no two people can agree what actually constitutes an ESG fund. Remember the old adage – “Never let the facts get in the way of a good story.”

To be clear, I like index funds, with the same proviso that goes with all investment instruments; educate yourself as to what you are buying.

They are not suitable for every market and the less efficient a market is the less suitable they are.

In an inefficient market it is much more likely that active management and proper company analysis and research will deliver superior investment performance. It is also true that an inefficient market will likely have more than its fair share of illiquid and expensive stocks.

ETFs and index funds have also contributed to significant fee pressures for actively managed funds as passive funds are generally lower cost. As it happens, they are not as cheap as they appear, but more on that later. In addition, the more index funds tracking a particular market are available the lower the flow of funds into actively managed funds.

I got to thinking about this topic shortly after Russia invaded Ukraine. Amidst the general global outrage there were calls to exclude Russian companies from emerging markets indices.

It took a week for MSCI and FTSE to make the change and the changes only became effective later. That meant that index investors in emerging markets were stuck holding Russian stocks that fell more than 50 per cent in a couple of days.

To add insult to injury, when the ETFs came to sell the shares, trading in these companies had been halted in all western exchanges and it was nigh on impossible to trade them in Moscow.

In this case, albeit an extreme one, ETFs caused a great deal of harm to their investors.

The Russian example is a bit of a one-off (hopefully) but there are other reasons why ETFs might not make such great investments. It is a curious truth that the main S&P and MSCI thematic indices are weighted against profitable “quality” shares and value companies. This was shown in an article in the Journal of Beta Investment Strategies by David Blitz (Winter 2021). The article was pointed out to me, and surprised me, as I bet it would a lot of participants in the ETF market.

This means that in essence, thematic indices are heavily geared towards expensive and unprofitable stocks, so called “glamour” stocks.

As such, passive funds following these thematic indices are likely to invest in overpriced and overhyped stocks. That is fine if the overpriced, glamour stocks perform well but if there is a change in market leadership towards quality value stocks then the more active manager can and probably will perform much better.

All investors know (or should know) that every study undertaken into the performance of value stocks shows their tendency to perform better than the broader market over any decent time frame.

To the more casual market participant the range of thematic funds and ETFs, as well as the sheer number of indices that have been created can seem quite bewildering and off-putting.

One might reasonably think that such a market would be competitive, and pricing would be keen, all things being equal. Alas, this is the real world, all things are not equal and are not necessarily what they seem.

The fees paid for a thematic fund are usually much less than half of that which you would pay an active manager so, on the face of it, they are perceived as good value.

The problem lies in two parts. The first is that if you buy an ETF, it will almost certainly be from one of only five suppliers who dominate the market (Ishares, Vanguard, StateStreet, Invesco and Schwab).

Secondly, these ETFs will track indices from a similarly concentrated group of providers, namely S&P Dow Jones, CRSP, FTSE, MSCI and Nasdaq. Ironically, despite the spirit of democratisation associated with low-cost indexing, it has fallen victim to a set of classic oligopolies.

Therefore, index providers have large market power and can demand high licensing fees.

Meanwhile, because ETFs are mostly a commoditised scale industry, smaller providers have limited ability to compete with the dominant market players as they lack economies of scale.

Researchers have estimated that 60% of index licensing fees are mark-ups by the index providers to ETF sponsors and that ETF fees could be 30% cheaper in a more competitive market.

Given that prices are already low, this does seem a bit odd. It seems that while ETFs are efficient, the ETF industry is not.

Upon reflection, perhaps cat skinning would be easier.

David Clark is investment director at Saracen Fund Managers