“Too much of a good thing,” said Mae West, “can be wonderful.” Too much of a good thing might also make investors wonder.
Over the past year, $310 billion has fled actively managed funds run by people who try (and often fail) to pick the best stocks and bonds. Meanwhile, $409 billion has poured into passive, or index, funds that seek to match the market rather than beat it. Could these autopilot portfolios become so popular that they distort the financial markets?
A report this past week from investment firm Sanford C. Bernstein, titled “The Silent Road to Serfdom: Why Passive Investing Is Worse than Marxism,” warned that index funds might grow to the point at which new investments could be massively mispriced. The tone of the report was a little operatic, but the question it raised is deadly serious.
And a group of researchers at the University of Amsterdam in the Netherlands recently argued that the rise of giant index-fund managers, including BlackRock and Vanguard Group, could lead to a concentration of ownership unrivaled since the days when John Pierpont Morgan and John D. Rockefeller controlled vast tracts of the economy.
Of course, those titans primarily represented their own interests, while the index funds are legally bound to act on behalf of the millions of savers who own them.
The machines that run index funds slash the costs of investing by 90% or more by skipping most of the research and trading their human rivals engage in, instead owning essentially all the stocks or bonds in a market basket all the time.
If businesses are to be able to raise capital by selling shares to outsiders, “you need a deep market of active investors willing to take a view on the valuation of the company,” Inigo Fraser-Jenkins, head of quantitative strategy at Bernstein in London and lead author of the “Worse than Marxism” report, told me this week.
Back in 1999, active stock pickers decided that eToys, with $30 million in revenues, should sell stock to the public at a total value of $2 billion. It went bust two years later, so you might wonder how good active managers are at pricing new issues.
Yet Mr. Fraser-Jenkins has a point. Index funds don’t set prices; they only accept the prices that active investors have already set. If everyone owned index funds, he says, “no one would be doing” the job of figuring out what securities are worth.
Even John C. Bogle, the founder of Vanguard Group who launched the first index mutual fund 40 years ago this month, agrees that passive investing can get too big for anybody’s good.
“What happens when everybody indexes?” he asks. “Chaos, chaos without limit. You can’t buy or sell, there is no liquidity, there is no market.”
But, he adds, that would require indexing to grow immensely from today’s levels. Probably not until passive funds are at least 90% of the market could such chaos arise, he argues.
That’s largely because index funds trade so much less often than active managers. On a typical day, only 5% to 10% of total trading volume comes from index funds, says a Vanguard spokesman. So there’s still plenty of room for active funds to set prices.
Still, index funds are growing so large that they may “fundamentally reshape the way corporate ownership is organized,” says Eelke Heemskerk, a political-science professor at the University of Amsterdam.
The Heemskerk research team estimates that the two largest index-fund managers, BlackRock and Vanguard, already own at least 5% of more than 2,600 and 1,800 companies worldwide, respectively. Spokesmen for the fund managers say those numbers are fairly accurate.
Index funds don’t “vote with their feet” by selling when they disagree with companies’ managers. They are quasi-permanent investors.
Because corporations know that, says Prof. Heemskerk, coziness and complacency may arise. “If you have only long-term investors, how do you keep management on their toes?” he asks. “Where are the checks and balances when you have such large block holdings?”
A spokesman says BlackRock is vigilant even about its quasi-permanent holdings: “Our long-term engagement with companies leads to better outcomes, since they have an understanding of our views and recognize the validity of our concerns.”
Funds run by Vanguard hold roughly 6% of total U.S. stock-market value, says a spokesman: “Given our size and stature, we are an important voice today in corporate-governance matters and vote to the sole benefit of our mutual-fund shareholders. Any incremental growth is not going to change that.”
Economists showed long ago that in a market in which everyone has equal information, it must pay off for someone to make the extra effort to obtain superior information. So active management is unlikely ever to disappear.
Though there are no clear harms yet from index funds, the rhetoric against them will keep escalating. Don’t be passive about this topic. Pay attention.
First appeared at WSJ