From The Atlantic, April 2021:
[Some] Economists and [some] policy makers are worried that the Vanguard model of passive investment is hurting markets.
The stock market has had quite a year. Plenty of cash is sloshing around, the pandemic recession notwithstanding, thanks to loose monetary policy, rampant inequality, crypto-speculation, and helicopter drops of cash. Plenty of bored people are reading market rumors on the internet, pumping and dumping penny stocks, riding GameStop to the moon, and bidding up the price of esoteric currencies and digital artworks. The markets are swooning and hitting new highs as kitchen-table investing—laptop-on-the-couch investing, really—is having a heyday not seen since the late 1990s.
Yet [some] economists, policy makers, and investors are worried that American markets have become inert—the product of a decades-long trend, not a months-long one. For millions of Americans, getting into the market no longer means picking stocks or hiring a portfolio manager to pick them for you. It means pushing money into an index fund, as offered by financial giants such as Vanguard, BlackRock, and State Street, otherwise known as the Big Three.
With index funds, nobody’s behind the scenes, dumping bad investments and selecting good ones. Nobody’s making a bet on shorting Tesla or going long on Apple. Nobody’s hedging Europe and plowing money into Vietnam. Nobody is doing much of anything at all. These funds are “passively managed,” in investor-speak. They generally buy and sell stocks when those stocks enter or exit indices, such as the S&P 500, and size their holdings according to metrics such as market value. Index funds mirror the market, in other words, rather than trying to pick winners and losers within it.
Thanks to their ultralow fees and stellar long-term performance, these investment vehicles have soaked up more and more money since being developed by Vanguard’s Jack Bogle in the 1970s. At first, Wall Street was skeptical that investors would accept making what the market made rather than betting on a market-beating return. But as of 2016, investors worldwide were pulling more than $300 billion a year out of actively managed funds and pushing more than $500 billion a year into index funds. Some $11 trillion is now invested in index funds, up from $2 trillion a decade ago. And as of 2019, more money is invested in passive funds than in active funds in the United States.
Indexing has gone big, very big. For nine in 10 companies on the S&P 500, their largest single shareholder is one of the Big Three. For many, the big indexers control 20 percent or more of their shares. Index funds now control 20 to 30 percent of the American equities market, if not more.
Indexing has also gone small, very small. Although many financial institutions offer index funds to their clients, the Big Three control 80 or 90 percent of the market. The Harvard Law professor John Coates has argued that in the near future, just 12 management professionals—meaning a dozen people, not a dozen management committees or firms, mind you—will likely have “practical power over the majority of U.S. public companies.” This financial revolution has been unquestionably good for the people lucky enough to have money to invest: They’ve gotten better returns for lower fees, as index funds shunt billions of dollars away from financial middlemen and toward regular families. Yet it has also moved the country toward a peculiar kind of financial oligarchy, one that might not be good for the economy as a whole.
The problem in American finance right now is not that the public markets are overrun with failsons [an incompetent, unsuccessful middle-class or upper-class man who is protected from economic duress by his family's wealth or influence] picking up stock tips on Reddit, investors gambling on art tokens, and rich people flooding cash into Special Purpose Acquisition Companies, or SPACs. The problem is that the public markets have been cornered by a group of investment managers small enough to fit at a lunch counter, dedicated to quiescence and inertia.
Before index funds, if you wanted to get into the stock market, you had a few choices. You could pick stocks yourself, using a broker to buy and sell them. (Nowadays, you can easily buy and sell on your own.) Or you could buy into a mutual fund—a collection of investments selected by a vetted manager, promising solid returns in exchange for an annual fee.
Then Bogle, the head of a mutual-fund company, turned on the industry. He argued that mutual-fund fees were exorbitant, that mutual funds generally failed to beat the market, and that fund employees had an obvious conflict of interest: Was their priority to maximize returns for the people who bought into the mutual fund, or to make money for the company? He set up a company called Vanguard offering a new kind of mutual fund, one that would buy and hold every stock or bond on a major index and that would devote itself to driving fees as low as possible. Other companies, including Fidelity, State Street, and BlackRock, soon mimicked this strategy, later adding exchange-traded options, or ETFs.
The strategy sounds implausible. But it works. Passively managed investment options do not just outperform actively managed ones in terms of both better returns and lower fees. They eat their lunch.
Let’s imagine that a decade ago you invested $100 in an index fund charging a 0.04 percent fee and $100 in a traditional mutual fund charging a 1.5 percent fee. Let’s also imagine that the index fund tracked the S&P 500, and that the mutual fund ended up returning what the S&P 500 returned. Your passively invested $100 would have turned into $356.66 in 10 years. Your traditionally invested $100 would have turned into $313.37. Actively managed investment options could make up for their higher fees with higher returns. And some do, some of the time. Yet scores of industry and academic studies stretching over decades show that trying to beat the market tends to result in lower returns than just buying the market. Only a quarter of actively managed mutual funds exceeded the returns of their passively managed cousins in the decade leading up to 2019, according to research by Morningstar. That joke about meditation applies to money management too: Don’t just do something; sit there.
Compelled by the math, millions of investors have decided to do less to make more. Competition among the firms offering index funds has driven fees to scratch—some funds charge no fees at all—versus 1.5 percent or more, sometimes much more, for actively managed options. Cash has poured in. Now passive is bigger than active.
While that shift has redounded to the benefit of the Vanguards of the world, it has also redounded to the benefit of retail investors. Index funds mean less money for mutual-fund managers and more money for Mom and Dad: According to Morningstar, investors saved $6 billion in fees by switching to passive management in 2019 alone. “This is on-net positive for society,” Jonathan Brogaard, a finance professor at the University of Utah’s David Eccles School of Business, told me. “You are getting the same exposure to the markets for a tenth of a cost. It’s a no-brainer.”
What might be good for retail investors might not be good for the financial markets, public companies, or the American economy writ large, and the passive revolution’s scope has raised all sorts of hand-wringing and red-flagging. Analysts at Bernstein have called passive investing “worse than Marxism.” The investor Michael Burry, of The Big Short fame, has called it a “bubble,” and a co-head of Goldman Sachs’s investment-management division has warned about froth too. Shortly before his death in 2019, Bogle himself warned that index funds’ dominance might not “serve the national interest.”
One primary concern comes from the analysts at Bernstein: “A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active, market-led capital management.” The point of their research note, if rendered a touch inscrutable with references to Hayek and the Gossnab, is about market signals and capital allocation.
Active managers direct investment dollars to companies on the basis of those companies’ research-and-development prospects, human capital, regulatory outlook, and so on. They take new information and price it into a company’s stock when buying and selling shares. If Company A’s stock price tanks when it announces a major scandal, that’s because active investors are selling. If Company B’s shares soar when it announces it’s entering a new market, that’s because active investors are buying.
Passive investors, by contrast, ignore annual reports and market rumors. They do nothing with trading-floor gossip. They make no attempt to research what to invest in and what to skip. Whether holding international or domestic assets, holding stocks or bonds, or using a mutual-fund structure or an ETF structure, they just mirror the market. Big U.S.-stock index funds buy big U.S. stocks just because they’re big U.S. stocks.
That commitment to inertia worries the Bernstein analysts, who point out that in a world with exclusively passive investors, capital will get allocated only to the big companies and not necessarily to good, promising, or efficient companies. A gravitational, big-getting-bigger effect would dominate stock-price movements. At least in a Soviet-type centrally planned economy, apparatchiks would be making some attempt to allocate resources efficiently. The world the Bernstein analysts fear has not arrived, at least not yet: Passive management is merely a giant phenomenon, not an all-encompassing one. Hundreds of actively managed mutual funds are still out there, as are legions of day traders, hedge funds, and private offices buying and selling and buying and selling. Stock prices still move around, sometimes dramatically, on the basis of new data and new ideas.
Still, passive investing may well be degrading the informational content of the markets, messing up price signals and making business decisions harder as a result. Brogaard and two co-authors, Matthew Ringgenberg, also of the University of Utah, and David Sovich, of the University of Kentucky, have shown as much in a recent paper. They start with a look at a somewhat different kind of index fund: a commodity-futures index fund, which tracks the expected price of things such as gold and copper rather than the current price of Raytheon and Apple shares. Companies large and small base billions of dollars in expenditures on commodity futures. A firm might hold off on buying copper or rush a purchase of gold based on where it expects prices to go.
When one of these commodities ends up on an index, the firms that use that commodity in their business see a 6 percent increase in costs and a 40 percent decrease in operating profits, relative to firms without exposure to the commodity, the academics found. Their theory is that ETF trading shifts prices in subtle ways, making it harder for businesses to know when to buy their gold and copper. Corporate executives “are being influenced by what happens in the futures market, and what happens in the futures market is being influenced by ETF trading,” Brogaard told me.
More broadly, the Bernstein analysts, among others, worry that index-linked investing is increasing correlation, whereby the prices of stocks, bonds, and other assets move up or down or sideways together. As the financial economist Jeffrey Wurgler has written, the price fluctuations of a newly indexed stock “magically and quickly” change. A firm’s shares begin to move “more closely with its 499 new neighbors and less closely with the rest of the market. It is as if it has joined a new school of fish.”
Afar bigger concern is that the rise of the indexers might be making American firms less competitive, through “common ownership,” in which the mega-asset managers control large stakes in multiple competitors in the same industry. The passive firms control big chunks of the airlines American, Delta, JetBlue, Southwest, and United, for instance, as well as big chunks of Bank of America, Citi, JPMorgan Chase, and Wells Fargo. Name an industry with a significant number of publicly traded firms—auto, retail, fast food, agribusiness, telecom—and the same is likely to be true.
The rise of common ownership might be perverting corporate behavior in weird ways, academics argue. Think about the incentives like this: Let’s imagine that you are a major shareholder in a public widget company. We’d expect you to desire—insist, even—that the company fight for market share and profits. But now imagine that you are a major shareholder in all the important widget companies. You would no longer really care which one succeeded, particularly not if one company doing better meant another company doing worse. You’d just care about the widget sector’s corporate profits, which would go up if the widget companies quit competing with one another and started raising prices to pad their bottom line.
The research on whether common ownership is in fact reducing competition is murky, contested, and sometimes contradictory. Still, one major paper showed that common ownership of airline stocks had the effect of raising ticket prices by 3 to 7 percent. A separate study showed that consumers are paying higher prices for prescription medicines because generic-drug makers have less incentive to compete with the companies making name-brand drugs. Yet another study showed that common ownership is leading retail banks to charge higher prices.
Asset managers have pushed back hard, describing this research as baseless and incoherent. “The economics literature purporting to link index funds and higher prices is based on fragile evidence and fundamental misconceptions,” one BlackRock white paper on the subject argues. “It does not provide a plausible causal explanation of how common ownership can lead to higher prices.”
Nobody is arguing that asset managers are facilitating corporate collusion or encouraging managers in rival firms to stop competing. New research suggests that common ownership could alter corporate executives’ financial incentives “without communication between shareholders and firms, coordination between firms, knowledge of shareholders’ incentives, or market-specific interventions by top managers.” Across firms, executive compensation seems to be more closely linked to a company’s performance when its shareholders are not invested in the company’s rivals, the study found. In other words, firms stop paying managers for performance when owned by the same people who own their rivals.
The market clout of the indexers raises other questions too. The actual owners of the stocks—not the index-fund managers but the people putting money into index funds—have little say over the companies they own. Vanguard, Fidelity, and State Street, not Mom and Dad, vote in shareholder elections. As John Coates, the Harvard professor, notes: “For the most valuable public company in the world, three individuals can in principle swing the vote of 17 percent of its shares. Generally, a significant fraction of shareholders do not vote, even if in contested battles. As a result, the 17 percent actually represents more like 25 percent or more of the likely votes in contested votes. That share of the vote will generally be pivotal.” In fact, the Big Three cast roughly 25 percent of the votes in S&P 500 companies.
Another worry is that these firms are too passive rather than too powerful. They are committed to being as lean and hands-off as possible, in order to reduce their fees. They do not tend to get involved in shareholder actions or small-bore corporate management, perhaps in part because any one company doing well against its peers is not of interest to the indexers, who want more assets under management and higher corporate profits. It’s not easy being big.
Just last month, Senator Elizabeth Warren grilled Treasury Secretary Janet Yellen on whether BlackRock, with its $9 trillion in assets under management, is too big to fail. The Federal Trade Commission is contemplating whether the big index-fund families pose antitrust concerns. Government watchdogs have raised alarm bells about the revolving door, as the Biden administration continues to draw officials from the Big Three. In an interview with The Wall Street Journal, the chief executive officer of State Street said he thought it was “almost inevitable, when you see this kind of concentration, that it probably will make sense to do something about it.”
But figuring out what the appropriate restrictions are depends on determining just what the problem with the indexers is—are they distorting price signals, raising the cost of consumer goods, posing financial systemic risk, or do they just have the market cornered? Then, what to do about it? Common ownership is not a problem the government is used to handling.
Yet, thanks to the passive revolution, a broad variety and huge number of firms might have less incentive to compete. The effect on the real economy might look a lot like that of rising corporate concentration. And the two phenomena might be catalyzing one another, as index investing increases the number of mergers and makes them more lucrative.
In recent decades, the whole economy has gone on autopilot. Index-fund investment is hyperconcentrated. So is online retail. So are pharmaceuticals. So is broadband. Name an industry, and it is likely dominated by a handful of giant players. That has led to all sorts of deleterious downstream effects: suppressing workers’ wages, raising consumer prices, stifling innovation, stoking inequality, and suffocating business creation. The problem is not just the indexers. It is the public markets they reflect, where more chaos, more speculation, more risk, more innovation, and more competition are desperately needed.
The antidote lies not just in fixing passive investment, but in making markets be markets again. Perhaps we could all use a little more of that manic stock-picking energy, not less.