Passive investing: worse than Marxism?

Investors are debating the Sanford Bernstein report which warns that the growth of index funds may distort markets, but such concerns are not new

 

Active fund management is in retreat, with investors increasingly flocking to low-cost passive investing strategies, but is there a danger of overshoot? Could financial markets ultimately be destabilised if investors continue to pile into index funds?

The potential risks surrounding the growth of passive investing have been hotly debated over the past fortnight, following a high-profile report from US investment firm Sanford Bernstein, unforgettably titled The Silent Road to Serfdom: Why Passive Investing Is Worse than Marxism.

Passive investing strategies, whereby investors buy cheap index-tracking funds rather than more expensive active funds that attempt to outperform stock markets, have been rising in popularity for many years now. In the US, almost a third of investor assets now rest in passive funds, their market share having roughly tripled since 1998.

In April, Vanguard founder and indexing advocate John Bogle noted index equity funds have seen net inflows of $1.5 trillion since 2007, while some $500 billion has poured out of active funds – “a $2 trillion swing in the preferences of equity investors, the likes of which I have never before seen during my 65 years in this field”.

Since then, the trend has accelerated: June saw $21.7 billion flow out of actively managed US equity funds, the worst monthly figure since October 2008, according to Morningstar. Over the past year alone, active equity funds have suffered net outflows of $236 billion; in contrast, passive funds have taken in $229 billion.

This trend is expected to continue. Actively managed equity funds’ annual fees are often 10 times higher than those of index funds, a differential that is increasingly being noted by cost-conscious investors.

Marxist hyperbole

Despite the hyperbolic title of its report, Sanford Bernstein is not actually disparaging passive investing, noting that its growth “has been a huge benefit to asset owners in enabling them to cut their costs”. However, while policymakers may see this growth as “entirely benign”, the broader financial system may lose out if active management “suffers a catastrophic demise”.

Its point is that active fund managers, by keeping a watchful eye as to whether particular stocks may be overvalued or undervalued and by undertaking detailed research, help make markets more efficient.

Index funds, in contrast, make no such judgments, instead relying on prices set by active investors. Of course, if everyone was invested in index funds, there would be no active fund managers around to do all that detective work, resulting in market mispricing and the misallocation of capital. Badly-run companies would continue to attract investors solely because they are included in an index.

Capitalist economies rely on the market to allocate capital, whereas Marxists attempt to “optimise the flows of capital” by central planning. In contrast, passive investment management does neither, no one is attempting to effectively allocate capital.

Thus, regulators must remember active investment decisions “form a crucial part of the capital allocation process in an economy and as such there is a clear and distinct social worth in their aggregate action”.

Sceptics might point to the dotcom and housing bubbles as evidence that Sanford Bernstein is overstating this “clear and distinct social worth”. Others might argue this is mere philosophising and that even if active management is in secular decline, it can never vanish entirely.

If index-dominated stock markets became increasingly inefficient at reflecting information, “then it will pay someone to jump into the market”, as indexing guru Burton Malkiel put it recently. The same point was made last year by John Bogle: “we would have chaos in our markets” if everyone indexed, he admitted, but the odds of that are “zero”.

Too large?

Nevertheless, few observers would disagree that Sanford Bernstein is entitled to ask: “How large can passive get? Can it become too large?”

As noted earlier, passive investing remains a minority sport, despite its rapid growth; 32 per cent of US equity assets are passively managed and that percentage is lower still outside the US. Bogle estimates markets “may get less inefficient at 80 per cent indexed” but not before then. Nor is Malkiel bothered, saying he “might start to worry” if 95 per cent of investors were indexing but there will “always” be enough active investors “to make sure that information gets reflected quickly”.

Others disagree. Earlier this year, high-profile hedge fund manager Bill Ackman warned the flow of money into index funds was bloating the value of stocks in well-known benchmarks compared to non-index stocks, and some data seems to support that contention. S&P Capital IQ data suggests that at the end of 2015, stocks in the small-cap Russell 2000 index were trading at a premium of 50 per cent to similar non-index stocks. Furthermore, this premium has been rising notably over the past 10 years.

Market consequences

The rise of indexing is also noted in a 2010 paper, On the Economic Consequences of Index-Linked Investing, by New York University’s Prof Jeffrey Wurgler. Between 1990 and 2005, Wurgler found, the addition in stocks to the S&P 500 index resulted in price increases of almost 9 per cent, with this effect rising over time as index assets increased. Stocks deleted from the index tumbled by an even greater amount.

Furthermore, stocks begin to behave differently after being added to the index. Co-movement increases: the stock “begins to move more closely with its 499 new neighbours and less closely with the rest of the market. It is as if it has joined a new school of fish”.

The evidence, Wurgler concluded, is that “stock prices are increasingly a function not just of fundamentals but also of the happenstance of index membership”, adding that “the magnitude of the economic distortions they cause” needed to be considered by regulators.

Similar points are made in a 2012 paper, How Index Trading Increases Market Vulnerability. Co-movement in stocks has increased almost fourfold since the mid-1990s, the study found, with the most likely explanation being investors’ increased use of exchange-traded funds (ETFs). With stocks increasingly rising and falling en masse, this results in less diversified portfolios, “contributes to higher systematic equity market risk” and an increased “fragility” in stock markets.

While no one can deny that correlations have increased in recent years, indexing may not be the only or even the main cause. The rise of electronic trading and the increased role played in markets by global central banks may be factors, as might the rise of benchmarking – that is, the increased tendency to measure active funds’ performance against a particular benchmark.

Overall, however, the paper argues there is “compelling evidence” that the rise in passive investing “meaningfully corresponds to a decrease in the ability of investors to diversify risk in recent decades.”

Governance concerns

There is another charge commonly levelled at index funds, namely that their growth negatively impacts on corporate governance. The flow of money into passive funds mean the biggest indexers – Vanguard, Blackrock and State Street – will typically have large stakes in all the world’s major companies. Indexers’ focus on low fees and cost control means they may not be inclined to invest the time and funds required to oversee the world’s biggest companies, Bill Ackman has argued.

Others note that active funds can hold badly-run or unethical companies to account by threatening to sell their shares. In contrast, indexers “can’t sell those stocks even if they are terrible companies”, as Blackrock chief executive Larry Fink admitted last year.

That doesn’t mean indexers are powerless – Fink added that Blackrock “was taking a more active dialogue with our companies” and “imposing more of what we think is correct”. A recent study, Passive Investors, Not Passive Owners, suggests this approach has merit. It found that an increase in ownership by passive institutions is associated with more independent directors, fewer restrictions on shareholders’ ability to call special meetings, less support for management proposals and more support for shareholder-initiated governance proposals.

Passive investors seem to exert influence through their large voting blocs, the study found, resulting in them playing a “key role in influencing firms’ governance choices”.

Contrary to conventional wisdom, it appears passive funds are unafraid to aggressively represent the interests of their shareholders when dealing with company management. However, the central question raised by Sanford Bernstein – how large is too large for the passive investing industry? – is likely to prove a more difficult question to answer, and one that gets increasing attention in coming years as more and more money makes its way into index funds.

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