CHICAGO — One thing that has changed for me over the past decade is that I no longer try to convince people that indexing is superior to active investing. Perhaps I don’t tout indexing as much these days because I am a bit concerned that indexing is becoming too large and regulators may act to limit size.
This was the topic of a session I attended at the Morningstar Investment Conference, which examined two potential dangers from over indexing: lack of price discovery and lack of corporate governance.
Morningstar data indicate that 49% of U.S. stock funds are indexed and this trend shows no signs of slowing, according to Morningstar’s director of passive strategies and sustainability research, Hortense Bioy. Active funds are losing share and will soon be in the minority, according to Bioy.
Could active funds really become extinct? I say no.
Most assets in U.S. stocks are not owned by funds, so index funds are not nearing half of U.S. stock equities, noted consultant Jasmine Sethi who spoke on the panel. Funds are a minority of stock ownership, as pensions, hedge funds and others also own stocks. This is an important point I find many people miss.
There will always be active funds, said panelist Rakhi Kumar, head of ESG investments and asset stewardship at State Street, though he also noted the benefits investors receive from indexing, including diversification and low fees. Kumar stated active funds will only stop losing share when performance relative to indexing improves. I concur.
Indexing can lead to unintended consequences, such as ownership concentration by the largest index fund firms, including Vanguard, Blackrock and State Street, said panelist Eric Posner, a law professor at the University of Chicago. An over abundance of indexing may give these firms too much power, he added, possibly violating anti-trust laws.
Posner noted that this concentration leads to lower competition by the companies owned by the index funds, as the index fund families want all the companies in their indexes to increase cash flows. I didn’t buy that logic. He cited a study showing lower competition in the airline industry due to fund ownership concentration and the other panelists noted that study had been widely criticized.
He also suggested regulatory solutions to limit ownership share. My opinion is that limiting ownership increases costs and hurts investors.
Additional regulation is a real possibility, I believe, and I concur with Bioy who stated that the late Jack Bogle, the father of the index mutual fund, believed there would be some pressure to break up funds as a few fund families are becoming oligopolies.
My overall view, however, is that there is no evidence corporate governance has declined as a result of concentration by a few large index fund families. In fact, Morningstar’s own research notes, “The shift to indexing hasn’t led to the abdication of stewardship responsibilities.”
I own a few stocks but don’t even vote my proxies, and I feel comfortable that Vanguard has spent more time than I have reading proxies before voting on behalf of shareholders.
How many active investors it takes to keep markets efficient is debatable. Certainly 10% of investors could drive stock prices based on market conditions.
To come back to my original point: These days, when someone tells me they are beating the market, instead of advising them to index, I respond by congratulating them and telling them to keep doing what they are doing. They keep markets efficient.
In fact, I’ve even proposed a national holiday for active investors. Perhaps April 1 is a good day.
