How to think about the unstoppable rise of index funds

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They deserve scrutiny, not panic

Finance and economics | The Economist

THE HISTORY of modern finance is littered with ideas that worked well enough at small scale—railway bonds, Japanese skyscrapers, sliced-and-diced mortgage securities—but morphed into monstrosities once too many punters piled in. When it comes to sheer size, no mania can compare with that for passive investing. Funds that track the entire market by buying shares in every company in America’s S&P 500, say, rather than guessing which will perform better than average, have attained giant scale. Fully 40% of the total net assets managed by funds in America are in passive vehicles, reckons the Investment Company Institute, an industry group. The phenomenon warrants scrutiny.

Index funds have grown because of the validity of the core insight underpinning them: conventional investment funds are, by and large, a terrible proposition. The vast majority fail to beat the market over the years. Hefty management fees paid by investors in such ventures, often around 1-2% a year (and more for snazzy hedge funds), add up to giant bonuses for stockpickers. Index funds, by contrast, charge nearly nothing (0.04% for a large equity fund) and do a good job of hugging their chosen benchmark. Given time, they almost inevitably leave active managers in the dust.

“Trillions”, a new book by Robin Wigglesworth, a journalist at the Financial Times, chronicles the rise of passive funds from 1960s academic curiosity to 1970s commercial flop and then runaway success in the 2000s. It estimates that over $26trn—more than a year’s economic output in America—is now lodged in such funds. That is more than enough to set nerves jangling, given high finance has in the past built structures that turn out to be too big to fail.

Mr Wigglesworth, while broadly celebrating this passive revolution, also lays out where the pitfalls might lie. An obvious one is that index funds hand power to the companies that compile the indices. Once-dull financial utilities that reflected the performance of markets, such as MSCI, S&P and FTSE, now help shape them instead. Including a company’s shares in an index can force investors around the world to snap them up. The power of the index is indeed a potential shortcoming. But by and large the weakness is obvious enough for regulators and investors to guard against it.

Another concern is corporate governance. BlackRock, State Street and Vanguard, the three titans of passive investing, together own over 20% of large listed American firms (among other things). Although one person’s vote makes no difference, active managers who pick shares in a handful of companies will push for them to be well-run. Passive investors whose portfolio includes several hundred names might not be so fussed. That is worrying, given they could control the outcome of many a boardroom spat.

Passive giants respond that they are attentive owners, with staff dedicated to prodding the management of the companies they own. Better yet would be for their power to be diffused more widely. That is happening: BlackRock, which on October 13th announced it now manages $9.5trn in assets, plans to hand over some proxy-voting rights to the investors in its funds. This might also alleviate another concern, that companies owned by the same mammoth passive fund will not compete as energetically, lest their success damage other holdings in their shareholders’ giant portfolios.

The biggest gripe of asset managers is that tracker funds free-ride on stockpickers’ hard work. Even mediocre active funds, taken together, help direct capital to worthwhile companies (and away from poorly run ones). Inigo Fraser Jenkins of Bernstein, a broker, once decried passive investing as “worse than Marxism”: Soviet planners did a lousy job of allocating resources to promising ventures, but at least they tried. Index funds, however, revel in their passivity.

What to make of this risk? A market dominated by passive investors would indeed kick up concerns over whether capital is going to the right places. But domination is far from the case today. Active managers still play a big role in markets. Retail investing is vibrant (if sometimes over-exuberant). Private-equity firms keep public and private valuations broadly in line. Venture capitalists are flocking to startups.

Furthermore, the hypothetical flaws of passive funds must be set against the very real savings investors have made since they arrived on the scene. The effects of rising passivity are worth pondering, but not reversing.

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This article appeared in the Finance & economics section of the print edition under the headline "Passive aggressive"

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