channelchek

(Note: companies that could be impacted by the content of this article are listed at the base of the story [desktop version]. This article uses third-party references to provide a bullish, bearish, and balanced point of view; sources are listed after the Balanced section.)

Recently, Morningstar reported that US stock index funds and exchanged traded funds (ETFs) now hold more assets than the traditional actively managed funds, with passive funds making up 50.2% of the US stock mutual fund pie, while actively managed funds made up 49.8%. (1) This uncharted territory has intensified the calls from some very astute investors, including such names as Carl Icahn, Bill Ackman, Seth Klarman, and Michael Burry, that there is an “index fund bubble” that will not end well for investors. The “Big Three” index fund managers include Vanguard with a 51% share of the market, BlackRock with 21%, and State Street Global with 9%. With fees for index funds approaching zero in some cases, it is unlikely new competitors will reduce this concentration.

Actively Managed Funds Historically Underperform. Only 23% of all active funds topped the average of their passive rivals over the 10-year period that ended in June 2019, according to Morningstar. (1) And the specific funds that outperform the market each year change annually, making picking an active fund that will show long-term outperformance difficult.

Many Active Funds are Closet Indexers. Closet indexing is a strategy used to describe funds that claim to actively purchase investments but wind up with a portfolio not much different from the benchmark. (3) Some estimates indicate upward of 40% of all actively managed funds are closet indexers. (4)

Index Funds Provide Instant Diversification. Index funds provide an easy and affordable means of stock diversification, lowering the overall individual stock risk faced by small investors, a good thing. (5)

Lower Fees are Good for Investors. Index funds’ average fee is 0.1%, compared to around 1% for actively managed funds. (6) The higher active management fee not only impacts investors from the fee, but also the lost compounding of the excess fee over time. It has been calculated that a 1% fee difference could cost a millennial more than half a million dollars over time. (7)

The Only Downside is to Active Managers’ Compensation. Active mutual funds yield about $120 billion per year in fee revenue on about $12.5 trillion in managed assets. Hedge funds earn about $45 billion in fee revenue each year on $3.1 trillion in assets, which compares to just $4 billion per year of fees for index funds. As funds under active management decline, so will the fees generated, impacting fund managers’ pocketbooks.

The “Father” of Index Funds Issued a Warning. The father of index investing, John Bogle, before his death this past January, wrote “if historical trends continue, a handful of institutional investors will one day hold voting control of virtually every large US corporation…. It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the ‘Big Three’ might own 30% or more of the US stock market—effective control. I do not believe that such concentration would serve the national interest.” (1)

Index Funds and ETFs Are Active Funds. Despite their name and passive strategies, some believe index funds are actually de facto active funds with a buy-and-hold strategy. (4)

Index Funds Are Not Immune to the Laws of Supply & Demand. Being part of an index distorts what the true price of the stock would be in the absence of the stock being in the index. With a set number of shares outstanding, the basket of stocks of the index will rise in price with the increased popular demand of the index fund, perhaps more so than other stocks. (4)

Index Funds Rarely Challenge Management. Analysis of shareholder-voting records of the “Big Three” index firms shows they overwhelmingly support the decisions and pay packages of executives. According to Reuters, even when looking at the 300 worst-performing companies, the “Big Three” voted with management between 84% and 93% of the time, almost at the same level they supported all companies in the index. These numbers compare to large pension funds, such as the California Public Employees’ Retirement System, which opposed executive pay 53% of the time in the first seven months of 2019, and The New York State Common Retirement Fund, which opposed pay packages 27% of the time in 2018. According to Dorothy Lund, a law professor at USC’s Gould School of Law, with no mission to outperform market indices, index funds lack an incentive to ensure that portfolio companies are well run. (8)

Passive Investment Creates an Inefficient Market. As index funds continue to gain market share, and invest in every stock in the index, whether good or bad, some worry that the price-discovery mechanism has become fragile. (9)

Passive Investment Funds Can Reduce Competition Between Firms. University of Chicago law professor Eric Posner has expressed concern that the concentration of ownership of index funds is undermining competition. From 1995 through 2015, the proportion of companies that had the same large common ownership rose from 20% to 80%. With such large common ownership, the incentive for owners to demand competition between similarly owned firms, say Cocoa Cola and Pepsi, for example, is lessened.

The massive growth of assets invested in index funds has enabled small investors to enjoy significant advantages in both fee savings and diversification, both positive outcomes for investors’ overall returns. However, the rise of index funds has come with some cost, including an increasing concentration of ownership among a few large firms. The potential investment limitations of index funds likely will only be evident when the market endures a significant downturn. Stay tuned.

Sources: