Index funds: killing capitalism?

Even Jack Bogle was worried about the prospect of passive funds owning majority stakes in listed businesses.

931-plane-634

High flyers: asset managers own large chunks of listed stock

Vanguard founder Jack Bogle, who died last week, popularised passive investing (tracking the market rather than paying a fund manager to pick stocks on your behalf). He did investors a huge service by showing them how to cut costs and boost returns, making life much harder for closet trackers (see below) in particular, in the process. Yet even Bogle had concerns about the growth in indexing.

In one of his last articles for The Wall Street Journal, he noted that the "Big Three" passive asset managers Vanguard, Black Rock and State Street could easily grow to "own 30% or more of the US market effective control. I do not believe that... would serve the national interest".

A new study, "Common Ownership in America: 1980 2017", from Matthew Backus of Columbia University, Christopher Conlon of New York University and Michael Sinkinson of Yale School of Management, picks up on his concern.

They note that we've gone from an era when most stocks were owned by individuals, to one where most stocks are held within diversified portfolios by intermediaries, on behalf of their ultimate owners. In 1980, the share of the S&P 500 owned by fund managers with more than $100m in assets under management was below 40%. Now it's more than 80%. As a result, a single asset manager might own big chunks of every listed stock in a given industry.

The risk is that "when so many businesses have the same owners... rivalries between them weaken". If you own one airline, you want it to undercut its rivals. But if you own every airline, you want them to collude to keep prices and margins high. There's no explicit evidence that firms are doing this but concentration of ownership is now high enough to imply it would be worthwhile to do so, report the academics. This is not due to passive funds as such: it "is driven by a broader rise in diversified investment strategies, of which these firms are only the most recent incarnation".

Solutions are not easy Bogle argued that index funds should make their "engagement with corporate managers" as transparent as possible, and we've talked about the need for radical reform of shareholder democracy in MoneyWeek many times.

As to what it means for your money we love passive funds and the cheap access they give us to global markets; but don't discount genuine active management. In a world where many investors are on autopilot and the erosion of competitive stress is allowing flabby, wasteful companies to survive, there should be many more opportunities for competent active managers to spot mispriced opportunities and take advantage of them.

I wish I knew what a closet tracker was,but I'm too embarrassed to ask

Active funds do the opposite they charge higher fees and employ stock pickers in the hope that they will beat the market. However, as we note in the story above, and as Jack Bogle's success made clear, they often fail to do so. In practice it's an arithmetical inevitability that both active and passive funds will collectively underperform the market. After all, for every winner in a trade there's a loser. So in the end, the average investor gets the market return, less costs. The reason investors still invest in active funds is that they hope they'll pick a winner, rather than one of the many losers.

The trouble is, to beat the market convincingly you need to take risks perhaps by taking large positions in a smaller number of stocks. The danger then is that you underperform the market badly, even if only in the short run. In the past this has led to some active managers picking portfolios that differ little to the overall market although it is increasingly frowned upon. These funds are described as "closet trackers" and represent the worst of both worlds: they charge high active fees, but deliver a passive return.

There are ways to spot a closet tracker. You can simply look at its past performance and see how much it differs from the wider market. Or you can look at the active share. This compares how much a fund's portfolio differs from its benchmark index. The higher the score, the more active the fund (although of course, this doesn't necessarily mean it will outperform).

Recommended

Kieran Heinemann: the history of shareholder capitalism
Investment strategy

Kieran Heinemann: the history of shareholder capitalism

Merryn talks to Kieran Heinemann, author of Playing the Market: Retail Investment and Speculation in Twentieth-Century Britain, about the history of t…
17 Sep 2021
Why it pays to face up to your investment mistakes
Investment strategy

Why it pays to face up to your investment mistakes

Buying stocks can be a complicated business. But selling stocks can be tricky, too – even if you sell for the right reasons. Max King explains how to …
17 Sep 2021
A nightmare 1970s scenario for investors is edging closer
Investment strategy

A nightmare 1970s scenario for investors is edging closer

Inflation need not be a worry unless it is driven by labour market shortages. Unfortunately, writes macroeconomist Philip Pilkington, that’s exactly w…
17 Sep 2021
The UK jobs market is booming – what does that mean for investors?
UK Economy

The UK jobs market is booming – what does that mean for investors?

Unemployment in the UK is back to pre-pandemic levels, employers are desperate to hire more staff, and wages are rising. John Stepek looks at what tha…
14 Sep 2021

Most Popular

The times may be changing, but don’t change how you invest
Small cap stocks

The times may be changing, but don’t change how you invest

We are living in strange times. But the basics of investing remain the same: buy fairly-priced stocks that can provide an income. And there are few be…
13 Sep 2021
Two shipping funds to buy for steady income
Investment trusts

Two shipping funds to buy for steady income

Returns from owning ships are volatile, but these two investment trusts are trying to make the sector less risky.
7 Sep 2021
Should investors be worried about stagflation?
US Economy

Should investors be worried about stagflation?

The latest US employment data has raised the ugly spectre of “stagflation” – weak growth and high inflation. John Stepek looks at what’s going on and …
6 Sep 2021