With Meghna Chakrabarti
Sounding the alarm on index funds. How their runaway success has reshaped power and accountability in boardrooms and on Wall Street.
John Coates, professor of law and economics at Harvard Law School where he teaches corporate governance, mergers and acquisitions and finance. Member of the Investor Advisory Committee of the Securities and Exchanges Commission. (@jciv)
Michelle Singletary, financial journalist for the Washington Post. Author of the nationally syndicated personal finance column "The Color of Money." (@SingletaryM)
Index Funds: Notes From Our Guests And A Primer On The Issues At Play
Picking the right individual stocks to invest in can be difficult and time-consuming for the average investor. That's where index funds come into play.
Index funds are typically low-cost investment programs made up of stocks from many companies across many sectors. The ultra-low cost mutual funds follow an index like the Dow or the S&P 500. The diversity of these funds, managed by firms like Vanguard, help investors protect against volatility.
What's the danger, then, in this increasingly popular investment?
Because of their appeal, investment in index funds has grown to the point where just three management firms — Vanguard, State Street and Black Rock — are the majority shareholders more than 80 of large U.S. companies.
John Bogle, founder of The Vanguard Group, warns in a recent Wall Street Journal piece that we're headed to a world where less than 10 funds control every public company. The concerns surrounding this phenomenon fit into three categories, according to Harvard Law School professor John Coates: 1) corporate governance, 2) anti-trust regulation and 3) market volatility.
- There's a threat that organizations will be controlled by a small number of people with unsurpassed power. This might mean the concerns and interests of regular investors are drowned out.
- The growth of indexing, at its logical end, could mean overlapping ownership. (Let's say, for argument's sake, that one firm owned all of the companies in the airline sector.) That would incentivize an end to competition, improved services, etc.
- Markets — at their extremes — with a lot of money flowing in and out of indexes could give way to sudden and dramatic market fluctuations.
Despite these concerns, Coates does not want to kill index funds. As quoted in the Wall Street Journal: "Indexing has created real and large social benefits in the form of lower expenses and greater long-term returns for millions of individuals investing directly or indirectly for retirement."
Todd Gormley, professor of finance in the Olin Business School at Washington University in St. Louis, is not sold on the danger of index funds.
"Regarding Bogle’s WSJ piece, I was admittedly a bit surprised when I read it," he told On Point in an interview. "In particular, I’m surprised that he seems to be worried about the growth of indexing, of which he is a huge advocate. But, on closer inspection, it seems he is largely concerned about the concentration of voting power because of how Vanguard, BlackRock, and State Street currently dominate the index fund industry. I suppose there could be some issues with that, but he’s rather vague about what those concerns might be. Additionally, I’m not sure it is a good idea to start down the path of policy prescriptions until we identify exactly what we are concerned about and have evidence that the concentration of corporate ownership he is concerned about is leading to some adverse effects. On that front, I really don’t think there is any convincing evidence that index funds and their growth is having adverse effects. As you know, my research paper, 'Passive Investors, Not Passive Owners,' suggests they actually have a positive influence on governance. Moreover, my other forthcoming paper, 'Standing on the Shoulders of Giants,' suggests the growth of index funds is also making it easier for activists to monitor managers and improve shareholder value. So, bottom line, I don’t really see much evidence out there right now to be concerned about."
Coates and Gormley are mostly in agreement about the challenges facing the future of index funds.
"The challenge is — it's a dilemma, really, is what it is — we have a wonderful thing, the index fund, which we want to protect and preserve," Coates says. "In fact, when I present my paper, I jokingly call it 'How to Keep Vanguard Alive for the Next 30 Years.' I want to protect it.
"But on the other hand, again, when you've got 12 people in the room making decisions and very little transparency on how they're being made, there's this room for suspicion, at a minimum, and possibly conflict of interests between the managers of the funds and either their own investors or society more broadly. Vanguard already has pointed the way toward some of the things that could be done. For example, Vanguard has a committee, and on that committee, they keep off all their sales staff. They do that voluntarily, I think, as a way of showing their good faith to the world, but they're not required to. And another index provider wouldn't be obliged to do the same thing. So they mitigate one conflict which is just between their sales goals and their voting power."
From The Reading List
Wall Street Journal: "Bogle Sounds a Warning on Index Funds" — "There no longer can be any doubt that the creation of the first index mutual fund was the most successful innovation—especially for investors—in modern financial history. The question we need to ask ourselves now is: What happens if it becomes too successful for its own good?
"The First Index Investment Trust, which tracks the returns of the S&P 500 and is now known as the Vanguard 500 Index Fund, was founded on December 31, 1975. It was the first 'product,' as it were, of a new mutual fund manager, The Vanguard Group, the company I had founded only one year earlier.
"The fund’s August 1976 initial public offering may have been the worst underwriting in Wall Street history. Despite the leadership of the Street’s four largest retail brokers, the IPO fell far short of its original $250 million target. The initial assets of 500 Index Fund totaled but $11.3 million—falling a mere 95% short of its goal."
Financial Times: "Opinion: How passive fund managers can shape the corporate landscape" — "The growing concentration in banking since the financial crisis, with more and more activity conducted by financial institutions regarded as 'too big to fail,' is at least a well understood phenomenon. The growing concentration in asset management resulting from the rise of indexed and exchange traded funds is less understood, especially in relation to its consequences for corporate governance.
"The so-called big three indexed fund providers — Vanguard, State Street and BlackRock — are estimated to have controlled about 15 per cent of the S&P 500 in 2017. More broadly, more than 44 per cent of assets in US-domiciled equity funds are now managed passively, up from 19 per cent in 2009.
"If anything, these figures underestimate the power of passive fund managers because large numbers of shareholders do not vote, even in contested battles, so the voting power of those who do vote is leveraged."
St. Louis Post-Dispatch: "Index funds may be passive, but they seem to play well with activists" — "Index fund investing has become so popular that just three firms – BlackRock, State Street and Vanguard – collectively are the biggest shareholders in 88 percent of large U.S. companies.
"Some people think so much passive ownership is bad for corporate governance. One Wall Street strategist has called it 'worse than Marxism.' The worry is that because index funds can’t sell their shares, they won’t put pressure on underperforming corporate managers.
"The indexers counter that they take governance seriously and exert influence through the way they vote their shares. A new study co-authored by Todd Gormley, an associate professor of finance at Washington University’s Olin Business School, lends support to their argument.
"Gormley, with scholars from Boston College and the University of Pennsylvania, studied the interaction between passive funds and their polar opposites: activist investors who take a stake in a company and agitate for change.
"The parallel rise of activism and index investing may be no accident."
Madeleine D'Angelo and Brian Hardzinski produced this hour for broadcast.
This program aired on December 12, 2018.