How to think about the unstoppable rise of index funds
THISTORY modern finance is teeming with ideas that have worked well enough on a small scale – railroad bonds, Japanese skyscrapers, sliced and diced mortgage securities – but turned into monstrosities once too many punters turned up. piled up. When it comes to size, no fad can compare with that of passive investing. Funds that follow the whole market by buying stocks in all American companies S&P 500, say, rather than guessing who will perform better than average, hit a giant scale. 40% of total net assets managed by funds in America are in passive vehicles, estimates the Investment Company Institute, an industry group. The phenomenon deserves close examination.
Index funds have developed because of the validity of the fundamental idea behind them: conventional investment funds are, on the whole, a terrible proposition. The vast majority fail to beat the market over the years. The high management fees paid by investors in such companies, often around 1 to 2% per annum (and more for elegant hedge funds), add up to giant bonuses for stock pickers. Index funds, on the other hand, charge next to nothing (0.04% for a large equity fund) and do a good job of aligning with their chosen benchmark. Over time, they almost inevitably leave active managers in the dust.
“Trillions”, a new book by Robin Wigglesworth, journalist at the Financial Time, relates the rise of passive funds from academic curiosity from the 1960s to the commercial flop of the 1970s, then to dazzling success in the 2000s. He estimates that more than $ 26 billion, or more than a year of economic production in America, are now housed in these funds. This is more than enough to strain your nerves, as high finance has in the past built structures that have proven to be too big to fail.
Mr Wigglesworth, while widely celebrating this passive revolution, also outlines where the pitfalls could lie. One thing is obvious that index funds empower the companies that compile indices. Once boring financial services that reflected the performance of markets, such as MSCI, S&P and FTSE, now help shape them instead. Inclusion of a company’s shares in an index can force investors around the world to buy them. The power of the index is indeed a potential shortcoming. But overall, the weakness is obvious enough that regulators and investors can guard against it.
Another concern is corporate governance. BlackRock, State Street and Vanguard, the three titans of passive investing, together own more than 20% of large US listed companies (among others). While a person’s vote doesn’t make any difference, active managers who pick stocks in a handful of companies will push for them to be well managed. Passive investors with a portfolio of several hundred names might not be that fussed. This is worrying, given that they could control the outcome of many conference room discussions.
Passive giants respond that they are caring owners, with staff dedicated to driving the management of the businesses they own. Better still, their power would spread more widely. That’s what’s happening: BlackRock, which announced on Oct. 13 that it now manages $ 9.5 billion in assets, plans to cede some proxy voting rights to investors in its funds. It could also alleviate another worry, which is that companies owned by the same gigantic passive fund will not compete as vigorously, lest their success damage other holdings in their shareholders’ giant portfolios.
The biggest complaint from asset managers is that trackers fund the hard work of stockpickers. Even mediocre active funds, taken together, help direct capital to worthwhile businesses (and away from poorly run ones). Broker Inigo Fraser Jenkins of Bernstein once decried passive investing as “worse than Marxism”: Soviet planners did a lousy job allocating resources to promising companies, but at least they tried. Index funds, however, revel in their passivity.
What to think of this risk? A market dominated by passive investors would indeed raise concerns about whether capital is going to the right places. But domination is far from being the case today. Active managers still play an important role in the markets. Retail investing is dynamic (although sometimes too exuberant). Private equity firms keep public and private valuations broadly aligned. Venture capitalists are flocking to startups.
In addition, the hypothetical defaults of passive funds must be weighed against the very real savings that investors have made since entering the market. The effects of increasing passivity are worth pondering, but not reversed.
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This article appeared in the Finance & economics section of the print edition under the title “Passive Aggressive”