Passive fund management is a big success built on a big fallacy. The late Jack Bogle’s sales pitch encapsulates it: “Don’t look for the needle in the haystack. Just buy the haystack.”
That line is still highlighted in marketing by Vanguard, the mutual fund business Bogle founded. BlackRock and State Street, two other big US fund managers, have their own variants. The implication: funds that track stock and bond indices immunise their clients against human error.
That is impossible. Someone has to build the haystack in the first place. In this case, it is active managers, who select securities they believe will outperform. But Bogle’s reassuring line, combined with ultra-low charges, has created an industry that has hitched a lucrative free ride on the backs of stock pickers. It is so successful that index funds will soon face the issue that confronts all titans, from Standard Oil to Facebook: their outsized impact on business and society.
Vanguard and its two peers manage assets worth $15tn, most of it passively. That compares with a world stock and bond universe whose value is estimated at about $190tn by the US Investment Company Institute. Growth rates have been breathtaking. BlackRock, the largest of the Big Three, has increased client assets 20 times to $7tn over 15 years, according to S&P Global data.
There are no signs of let-up. The global value of regulated index funds powered past the $10tn mark recently. The reason? “Fees are infinitesimally small because index funds have spawned competition hugely beneficial to the investor,” says Ben Johnson of Morningstar, the fund-ratings group. Charges may be less than 0.1 per cent annually for the exchange-traded index funds in which he is an expert.
Private investors previously paid five to 10 times more to hold old-school mutual funds. Too often, traditional fund managers were rentiers, charging clients steeply to own the stock market.
Index funds have blown a hole in that business model. But stock pickers still control about four-fifths of world equities. Besides, there is no reason to believe equity pricing would seize up, even if active managers owned far less. That is good news for compilers of capitalisation-weighted indices, and the passive managers who use them. The Big Three’s economies of scale will continue rising for years, luring more assets.
At current rates, the Big Three will control over a quarter of S&P 500 equity by 2028, up from one-fifth in 2018, according to a paper last year from the National Bureau of Economic Research in the US. Their propensity to vote shares held for clients is above average, noted Lucian Bebchuk of Harvard Law School and Scott Hirst of Boston University. The Big Three are on course to control 40 per cent of the votes in American corporations in a couple of decades.
In a similar scenario, about a dozen people would set the agenda for US public companies, according to John Coates, another academic. That would be a dangerous concentration of power. Vanguard’s Jim Rowley argues “there is no monolithic index fund gobbling everything up — instead there is a very diverse set of index funds [run by each passive manager]”. This seems disingenuous. The employees of any company share common values — passive fund governance wonks included. The greater the dominance of a few investors, the worse for shareholder democracy.
Lobbying pressure on the Big Three will also grow. Following pressure from activists, BlackRock joined Climate Action 100+, which chivvies energy companies to cut emissions and announced new green funds. Some see that as good stewardship. But can investors whose votes are increasingly pivotal in takeovers and top appointments credibly claim to be passive? Not really. By voting, they are picking winners, or trying to, just like active managers.
You could say the same of a range of index funds that are investing in everything from modish green ventures to marijuana companies. Here, compilers at index groups such as MSCI make bigger subjective calls on inclusion than they would for purely capitalisation-weighted benchmarks. Even these old warhorses cause distortions. Businesses included in popular indices have lower financing costs than others. Companies from the former Soviet Union listed in London partly for this reason.
In the US, index funds stand accused of a far more incendiary anti-competitive impact. Their concentrated ownership of industries such as airlines and pharmaceuticals may push up travel and drug prices, some academics argue.
The validity of such concerns matters less than their growing currency. As huge businesses, the Big Three will provoke growing hostility from politicians and regulators. Modern capitalism’s crisis of legitimacy is a function of its scale and disengagement.
Groups that have accumulated trillions by outsourcing investment decisions look like a prime example of the problem. It is no longer enough for them point out how low their charges are. Before he died last year, Bogle wrote that if index funds owned more than 50 per cent of the stock market it would not “serve the national interest”. That is one quote you will not find displayed prominently on Vanguard’s website.