We have repeatedly warned about the problem of index funds, including VEA Chair Robert A.G. Monks’ book Citizens Disunited, with extensive data on “drone” companies (with stock ownership tracking the index) and VEA Vice Chair Nell Minow was one of the judges who selected Index Funds and the Future of Corporate Governance: Theory, Evidence and Policy for the top prize awarded by IRRCi.
A cover story in BusinessWeek titled “The Hidden Dangers of the Great Index Fund Takeover” says that the big three, Vanguard, Blackrock, and State Street, “are the most important players in corporate America. Whether they like it or not.”
If you hold a stock market index fund, congratulations. The S&P 500’s total return was a thumping 31.5% in 2019, and a fund that passively tracks that benchmark delivered almost all those gains, minus a tiny fee—perhaps just 0.04% of assets. Now here’s something you probably weren’t thinking about when you clicked on the box to choose an index fund in your 401(k) or IRA: You were also part of one of the biggest shifts in corporate power in a generation.
The index fund is one of a handful of unambiguously beneficial financial innovations. Before it caught on, investors routinely paid sky-high fees to active stockpickers who often delivered subpar returns. The near-universal popularity of index funds puts them up there with Social Security, Stevie Wonder, and streaming TV….
The fund companies say there’s nothing to worry about because they don’t vote as a bloc. And index funds don’t buy shares to pursue any special agenda—they just buy whatever’s in the index, usually in proportion to its market value. If passive managers weren’t grabbing up all these shares, similar power would likely be in the hands of active funds, which haven’t served investors nearly as well. Index fund managers are more technocrat than robber baron.
And yet voting power is voting power. The fund companies’ combined votes and back-channel jawboning, in which they make their views known to directors and chief executive officers, could swing the outcome of important matters such as mergers, major investment decisions, CEO succession, and director elections—even if no fund house has the ability to decide the outcome of such matters alone. They’re potentially the most powerful force over a huge swath of America Inc. Alarm bells have begun to go off with some regulators, as well as with an ideologically diverse array of academics and activists.
We would frame the concerns differently. We are less concerned by the concentration of voting power or even engagement than by the challenges of conflicts of interest (as thoroughly described by Vanguard founder John Bogle) and the collective choice problem (the amount of resources devoted to learning enough about proxy issues to vote them optionally is likely to be less than the pro rata benefit based on even significant share holdings).
We think the much more important concern should be the impact on the capital markets of having a majority of the stock managed by passive holders and fiduciaries whose risk tolerance is not compatible with robust oversight, whether by voting or by selling. We will continue to monitor and comment on this issue.