We have heard a lot of weird and convoluted theories about excessive CEO pay, but the one Felix Salmon takes on here may be the ultimate:
Who is to blame for bloated CEO pay? Your favored answer to that question will tend to reflect your prior beliefs, which is why high pay is now being blamed on index funds. That’s a stretch, but the fact is that investors in the stock market, broadly, are more part of the problem than they might like to admit.
Salmon explains that Wintergreen active manager David Winters, who, like most active managers has underperformed the market and the index funds that track it, would like us to believe that active management is still superior because it does not promote excessive CEO pay.
The 2.47 percent that Wintergreen charges, writes Winters in his annual letter, is in fact 39 percent cheaper than 4.3 percent, which he says is “the average management fee advertised by the leading S&P 500 index funds.”
Even Winters’ most devout followers could be permitted a raised eyebrow at this claim, since, obviously, passive S&P 500 index funds don’t charge anything near a 4.3 percent management fee. Indeed, their actual management fee is normally about one-hundredth of that amount.So what is Winters talking about? It turns out that his 4.3 percent number is basically the amount of stock that S&P 500 companies issue to their employees every year, as part of their various stock-based compensation plans. Winters seems to think that if it weren’t for passive investors voting for corporate compensation plans, that number would come down to zero, and that investors in those passive plans are therefore losing out, somehow, on that extra 4.3 percent. It’s not a fee, exactly, but it’s a cost, maybe? That ultimately shareholders shoulder. And Winters explicitly blames passive investors for the existence of that cost, as a part of his argument for why active investing is better.
This logic was recently dismantled, quite elegantly, by Jason Zweig in the Wall Street Journal. Passive investors don’t vote in favor of corporate compensation plans much more often than active investors do, and in any case the newly issued stock is, simply, an amount that corporate employees are paid for doing their jobs….Still, Winters does have a kernel of important insight, which is that shareholders shouldn’t be in favor of higher executive pay. The more money that is extracted from a business by its CEO and other senior executives, the less there is left over for shareholders.