November 8, 2017
November 8, 2017
The foundation of index investing began in the early 1970s and had its share of critics at the time. When John Bogle established the first index fund for retail investors in 1975 (now the Vanguard 500 Index Fund) one competitor called indexing un-American and famously called the fund ‘Bogle’s Folly’. The critiques were varied but many believed there was no way that investors would settle for the average return of an index when investment managers were thought to be adding so much value.
Needless to say, Mr. Bogle has had the last laugh. That fund, which started with a mere $11 million in assets, has now grown to a $580 billion behemoth. More importantly, the concept of index investing has become widely accepted and has recently seen a sharp increase in popularity. The objective of indexed, or passively-managed, portfolios is to match the returns of an index. This is in contrast to actively-managed portfolios which attempt to outperform an index. According to Morningstar, investors have added $1.3 trillion to passively-managed mutual funds and exchange-traded funds (ETFs) over the last three years. In comparison, actively-managed funds have had net withdrawals of $250 billion over the same timeframe.
But the growing popularity of passively-managed vehicles has once again drawn the attention of critics. Sanford Bernstein recently released a research paper that was subtitled, “Why Passive Investing is worse than Marxism,” which sounds eerily similar to the un-American claims Mr. Bogle faced in the ‘70s. Other researchers have concluded that passive investing is a bubble that will eventually burst. Hyperbole aside, the questions being asked are good ones. Namely, what is the impact if a growing proportion of the world’s assets are indexed? And is there a point at which the growth of passive management begins to cause a problem?
One concern critics raise is that the growth of indexing will lead to less efficient market pricing which could ultimately lead to lower economic growth. To understand this argument, we must first note that the stock market plays an important role in efficiently allocating investment capital. Well-run companies with attractive growth opportunities are rewarded with a lower cost-of-capital (higher stock price and lower borrowing costs) while the opposite is true for poorly-run companies. Critics of indexing argue that if a majority of investors just want to own the market, the market’s role as an efficient allocator of capital will be compromised, leading to reduced productivity and growth for the economy as a whole. (This concern is the central point of Bernstein’s ‘Marxism’ research report.)
Although this may be a valid concern if passive investing is taken to its extreme, we are nowhere near that point yet. Despite their recent growth, passively-managed assets are still a relatively small percentage of invested assets. Morningstar recently estimated that passively-managed strategies account for approximately 30% of all assets managed in the United States. Blackrock has estimated that less than 20% of global equities are indexed. It is unlikely that indexing is causing problematic price inefficiencies given the small proportion of the overall market it represents.
But could this ever become a problem if the size of passively-managed assets continues to grow? We believe this is also unlikely. If assets start to become mispriced due to the growth of passive management, active managers should be able to take advantage of these mispricings to generate excess returns. This would lead to growth in active management and a corresponding decline in passive management until these mispricings no longer exist.
Some have suggested that the growth in passively-managed assets has led to a speculative ‘bubble’ in the U.S. stock market. This argument is not much different than the market efficiency concern discussed in the prior section. To believe that passively managed vehicles are causing a bubble is to believe that these vehicles are causing mispricing (overvaluation) in the underlying securities. As stated above, the size of passive vehicles is still small relative to the overall market and should not be blamed exclusively for the valuation of the current market.
Some have also suggested that many passive investors are smaller and less sophisticated investors who may be quick to sell when sentiment changes. They worry that these investors are more likely to panic during a correction and may exacerbate the declines. This argument also does not seem to carry much weight as passive investing has been embraced by investors of all types and sophistication levels including individuals, large pension funds, insurance companies, foundations and endowments.
The growth in passively-managed portfolios has led to an increase in the ownership of U.S. companies by large investment management firms. In 2005, Vanguard funds held ownership of 5% or more in only three companies in the S&P 500 Index. Today, Vanguard holds a 5% stake in 468 companies in the S&P 500. It is estimated that passively-managed mutual funds and ETFs now collectively own 11.6% of the S&P 500 Index. The vast majority of that ownership is with only three companies: Vanguard, Blackrock, and State Street.
Some critics of passive investing worry about the concentrated ownership of these firms and the influence it potentially wields. Surprisingly, the criticisms are at opposite ends of the spectrum. Some are concerned that these firms may use their ownership to influence management too much while others are concerned that passive managers are not incented to hold management accountable at all.
It is difficult to prove whether either concern is valid. The Department of Labor has determined that fund companies have a fiduciary responsibility to represent the shareholders of their funds when voting proxies and there is no evidence that they have breached this duty. In addition, third-party attempts to judge the voting records of the three fund companies have shown that the companies have supported both management and activist policies over time.
The sharp growth in passively-managed portfolios is a relatively new phenomenon which has never happened before in the history of the markets. As it stands now, we believe many of the concerns about the growth in this area are overdone. That said, this trend will be an ongoing focus at BOS and within the broader financial industry.
 Morningstar Direct Asset Flows Commentary, Morningstar Manager Research, January 11, 2017
 Index Investing Supports Vibrant Capital Markets, Blackrock, October 2017
 Wall Street’s “Do-Nothing” Investing Revolution, Wall Street Journal, October 17, 2016
 See Houlihan Lokey, Activists Situations Practice, November 2015 for an example of one such report