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The pioneer of the index fund and founder of the Vanguard Group, Jack Bogle died on the 16th of January at the age of 89. Sometime this year, analysts at Morningstar Inc. say assets in passively managed U.S. equity funds are likely to surpass assets in actively managed funds. The rise of these passively managed funds has changed the asset management business and it is believed that they could start to have an effect on how public corporations are managed.

Indices are increasingly used as a tool to judge active management. With the option of buying the index in an ETF form in most cases investor isn’t simply focused on fees but also on performance. Something which passive investors might not realise is that active managers are effectively choosing their allocation to stocks. Moreover, if all fees were the same both in active and passive exactly 50% of actively managed money would beat the passive index while 50% would not (assuming only stocks inside the index were available for selection). Many active managers who do outperform over a long period of time buy stocks or bonds which aren’t in their benchmarked index; or up the beta or risk of their portfolios in good times and take measures to monitor this. Bill Gross who famously managed the PIMCO Total Return Fund referred to this as structural alpha.

The idea that index funds affect the valuation and pricing mechanism of stock has been a topic of discussion for years. Timothy O’Neill, the global co-head of Goldman Sachs called indexing “a bubble machine” that “guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up”. It’s quite a good story to grab a sensational headline, but I believe on closer inspection it’s not true. Put simply, this is because active managers make up in aggregate the weightings of the stocks in the index. William Sharpe (1991) pointed this out by saying that the total market portfolio and the portfolio of indexers are both market cap weighted. Thus making it inescapable that active managers collectively have to be market cap weighted too.

We should only be concerned then if somehow an investor pulls money out of a fund which only has undervalued equities. If an investor managed to do this theoretically it would be undermining the efficiency of the market as the undervalued equities would become more undervalued. This would effectively make the manager underperform the index. Even though I’ve never met an investment manager who has told me their investments are overvalued, we already know that it’s impossible for investment managers in aggregate to all hold undervalued equities. So if index funds don’t under or overvalue companies, what is the problem with them?

Some market participants have warned that the growth of passive, index-linked funds could pose a threat to the market. These concerns have been gaining traction with the view that less actively managed money betting on the price of securities may have an effect on the long-term efficiency of capital markets in another way than talked about above.

Recently a lot of focus has been put on the idea that index funds might encourage anti-competition. Why? Over-diversification. The case most often used to examine this is the Airline study that found airfares rose more on routes where there were high levels of cross-ownership by funds. Having said that this over diversification not only applied to index funds but other large diversified active managers. Effectively owning natural competitors can reduce incentives to compete against each other as each company is taking market share from the other. If this is extrapolated over the whole market it could lead to decreased efficiency in the economy.

Passive managers have increasing independent directors to the company’s board. A 10 percent increase in ownership by passive investors is associated, on average, with a 9 percent increase in share of directors that are independent according to a 2014 paper by Todd Gormley, Donald Keim, and Ian Appel.

These concerns about market efficiency and anti-competition may seem excessive at the moment; however, as with anything in the world of investments, no law or principle remains in effect forever and we will continue to monitor this closely.

 

Source: Azar, José and Schmalz, Martin C. and Tecu, Isabel, Anticompetitive Effects of Common Ownership (May 10, 2018). Journal of Finance, 73(4), 2018. Available at: SSRN

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