The fallacy behind the rise of passive fund management


Passive fund management is a great success built on a big mistake. The late Jack Bogle’s sales pitch sums it up well: “Don’t look for the needle in the haystack. Just buy the haystack.

This line is still prominently featured in marketing by Vanguard, the mutual fund company Bogle founded. BlackRock and State Street, two other major US fund managers, have their own variations. The implication: Funds that track stock and bond indices immunize their clients against human error.

It’s impossible. Someone has to build the haystack first. In this case, it is the active managers who pick the stocks they think will outperform. But Bogle’s reassuring line, combined with ultra-low charges, created an industry that enjoyed a lucrative free ride on the backs of stock pickers. Its success is such that index funds will soon face the problem facing all titans from Standard Oil to Facebook: their outsized impact on business and society.

Vanguard and its two peers manage assets worth $15 billion, most of it passively. This compares to a global universe of stocks and bonds estimated to be worth around $190 billion by the US Investment Company Institute. The growth rates have been mind-boggling. BlackRock, the largest of the Big Three, grew its client assets 20-fold to $7 billion over 15 years, according to data from S&P Global.

There is no sign of letting up. The aggregate value of regulated index funds recently passed the $10 billion mark. The reason? “The fees are infinitesimally small because index funds have generated extremely beneficial competition for the investor,” says Ben Johnson of Morningstar, the fund ratings group. Fees may be less than 0.1% per annum for exchange-traded index funds on which he is an expert.

Private investors used to pay five to ten times more to own old-fashioned mutual funds. Too often, traditional fund managers were rentiers, charging clients heavily to own the stock market.

Index funds have carved a hole in this business model. But stock pickers still control about four-fifths of global stocks. Furthermore, there is no reason to believe that stock prices would crash, even if active managers owned significantly less. This is good news for compilers of cap-weighted indices and the passive managers who use them. The economies of scale of the Big Three will continue to increase for years to come, attracting more assets.

At current rates, the Big Three will control more than a quarter of S&P 500 stocks by 2028, up from a fifth in 2018, according to a paper last year from the National Bureau of Economic Research in the United States. Their propensity to vote for stocks held for clients is above average, noted Lucian Bebchuk of Harvard Law School and Scott Hirst of Boston University. The Big Three are on track to control 40% of the votes in corporate America within decades.

In a similar scenario, approximately a dozen people would set the agenda for American public companies, according to John Coates, another academic. It would be a dangerous concentration of power. Vanguard’s Jim Rowley argues that “there is no monolithic index fund that gobbles it all up – instead, there is a very diverse set of index funds [run by each passive manager]”. It seems dishonest. Employees of any company share common values, including fans of passive fund governance. The greater the domination of a few investors, the worse the shareholder democracy.

Lobbying pressure on the Big Three will also increase. Following pressure from activists, BlackRock joined Climate Action 100+, which encourages energy companies to cut emissions and announced new green funds. Some see it as good stewardship. But can investors whose votes are increasingly crucial in takeovers and top appointments credibly claim to be passive? Not really. By voting, they choose winners, or try to do so, just like active managers.

You could say the same about a range of index funds that invest in everything from trendy green businesses to marijuana companies. Here, compilers of index groups such as MSCI make greater subjective calls for inclusion than they would for purely capitalization-weighted benchmarks. Even those old war horses cause distortion. Companies included in popular indexes have lower financing costs than others. Companies from the former Soviet Union are listed in London partly for this reason.

In the United States, index funds are accused of having a much more incendiary anti-competitive effect. According to some academics, their concentrated ownership in industries such as airlines and pharmaceuticals could drive up the prices of travel and medicine.

The validity of these concerns is less important than their growing topicality. As huge corporations, the Big Three will provoke growing hostility from politicians and regulators. Modern capitalism’s crisis of legitimacy depends on its extent and its disengagement.

Groups that have amassed trillions by outsourcing investment decisions seem to be a prime example of the problem. It is no longer enough for them to emphasize the modesty of their charges. Before he died last year, Bogle wrote that if index funds held more than 50% of the stock market, it would “not serve the national interest.” It’s a quote you won’t find prominently on Vanguard’s website.

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Letters in response to this column:

Focus on the haystack – not the needles / By Brendan P Geary, Washington, DC, USA

Assets versus liabilities: trust market forces more / By Jon Bird, Bedlington, Northumberland, UK

Buybacks eclipse inflows into ETFs and trackers / By Luis Arenzana, London W1, UK

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