Index investing is revealing the flaws in our model of shareholder capitalism

Big fund players like Blackrock should take a tougher stance on problems such as high CEO pay

Now that investors have embraced the idea of tracking the market rather than paying someone a lot of money to try to beat it, there are a lot of people trying to find fault with the shift to indexing.

That's because a lot of people are having their business models torn up underneath them, and they don't like it.

As a result, index investing (a term I prefer to "passive") is now getting blamed for everything from propping the market up artificially to undermining the very basis of capitalism.

One of these ideas actually makes a lot of sense but it points to a much deeper problem with share ownership in general.

The trouble with semi-detached ownership

I recently read part of an interesting paper by a group of US academics (Matthew Backus, Christopher Conlon and Michael Sinkinson) about the risks of "common ownership".

The problem is easiest to illustrate with an example. Say you've got a high street with two newsagents. The two of them compete with one another, trying to undercut one another's prices, find cheaper places to get their supplies, put together special offers the usual stuff.

The upshot is that as long as they work hard enough and there's enough business to go around, they both get to stay in business and make a profit, while consumers get the best prices for their goods. That's the beauty of competition.

But let's say that, although they trade under different names, the same person owns both shops. Suddenly the incentives are very different. The shops are still competing with each other. The manager of each shop still has sales targets to hit and they're both going to be trying to poach business from one another.

But the person at the top doesn't want them to compete too hard. Because it makes more sense for the overall owner for each shop to have slightly higher profit margins and for the pair of them to make more money as a result.

In a nutshell, this is what some people argue that the rise of index investing has done. The market for pure indexing is dominated by just a few big players Vanguard and Blackrock being by far the biggest. If a big chunk of the population is funnelling all their money into the market via Vanguard and Blackrock, then how good is that for competition and the health of capitalism?

For example, if you own one airline, then you want it to undercut its rivals and put them out of business. But if you own every airline, then it's actually better if they all go easy on each other. Consumers get done over, but shareholders make out and a lot of the end shareholders are those same consumers.

This seems like quite an esoteric argument, but more and more people are concerned about it. That includes Jack Bogle, the founder of Vanguard, who raised several concerns himself in the Wall Street Journal, for one of his last articles published before his recent death.

This risk of collusion between business rivals is not new. As Adam Smith said: "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."

So the idea that we can brush this off as a theoretical argument seems naive, at best. If there's a way, we already know full well that there's a will.

How to get shareholders to take ownership seriously again

However, what's really interesting is that the obsession with the damage that index funds are doing to the market is helping to reveal the very real conflicts of interest that already exist.

This is not really an issue that has come about because of the likes of Vanguard. It's simply that they've drawn attention to it with their sheer scale.

The reality, as my colleague Merryn Somerset Webbhas discussed on many occasions is that this and other distortions have been a problem for some time, stemming from the fact that fund managers rather than individuals are now the dominant owners of stock.

The basic problem is that the end-owners of shares are often disengaged or in many cases, effectively disenfranchised (try being an active individual shareholder via the average platform and you'll realise it takes a lot more work than it should). That leaves the intermediaries the fund managers in charge of making decisions that may not always be in the end-users' best interest.

The scandal of rocketing chief executive pay is one very obvious example of this abdication of responsibility, but it's far from the only one.

The question is: what does this mean in practical terms for you?

I think there are two major trends. One is that genuinely active investors really should benefit from this. If companies have been given an overly easy ride by their current owners, then anyone willing to look out for the worst examples and acquire a bit of clout should be able to make profitable changes. Investing with those sorts of active managers is worth doing.

Secondly, this will help to drive the big players like Vanguard and Blackrock to take a tougher stance on obvious problems such as overly high pay. After all, they are the ones in the firing line if they don't.

It'd be interesting to see, for example, if the likes of Vanguard or Blackrock might start investigating ways to engage owners of their funds. They wouldn't have to be asked to vote on every shareholder resolution but perhaps an annual or semi-annual questionnaire on default voting intentions or something similar might start to get investors thinking a bit harder about the companies they own.