The down view of index funds
Can we have too much of a good thing? Index funds are guided not by the wizardly stock-pickers of old but by number crunchers who buy lists of representative securities and hold them, rise or fall. They have cut costs and boosted profits for large and small investors.
Can we have too much of a good thing?
Index funds are guided not by the wizardly stock-pickers of old but by number crunchers who buy lists of representative securities and hold them, rise or fall. They have cut costs and boosted profits for large and small investors.
But U.S. and European professors scrutinizing the impact of the Big Three index-fund purveyors - BlackRock Inc., Vanguard Group, and State Street Corp. - say they see, in the triumph of indexing, not just a cheap way for investors to squeeze profits but also threats to capitalism as we know it.
Index funds and managers of index "strategies" now control 34 percent of global stocks by value, up from 25 percent just five years ago, writes Inigo Fraser-Jenkins, in a report last month for Sanford C. Bernstein, New York.
A paper by political economist Jan Fichtner and two colleagues at the University of Amsterdam says the Big Three index-fund managers "represent the largest shareholder in 88 percent" of the S&P 500. These managers are "arguably exerting hidden power" over hundreds of big U.S. companies by backing management in most shareholder disputes, by "herding" shareholders into narrowly concentrated investments, threatening to make markets more volatile, and by pushing up consumer prices.
Other critics worry a market dominated by index funds will make capital scarce for new firms that aren't on any index.
In painting index funds as a threat to American consumers, Fichtner and his colleagues cite research by the Spain-based economist Jose Azar and his collaborators, who found heavy index-fund ownership correlates with higher prices, both in U.S. banking and in U.S. air travel, two industries in which most competitors are big, publicly traded companies.
"It is ironic that we are seeing an increase in criticism" of index funds around the 40th anniversary of Vanguard's introduction of its first index funds, says Vanguard spokesman John Woerth. He noted that the company has long faced criticism from high-fee "active" stock-pickers and brokers threatened by index funds' long-term higher performance and lower fees.
"Index funds have considerably improved outcomes for investors," Woerth said, citing fund-industry data. Just because index funds own a lot of shares doesn't mean they "control" firms, Woerth added. "There is nothing hidden here," he concluded: Vanguard votes "in the sole interest of our fund shareholders."
But fund managers don't need to engage in collusion to pursue joint goals at the potential expense of consumers and others, Azar told me.
"Common ownership by asset managers predicts higher prices in airlines and banking," he said, citing papers he published with colleagues at the University of Michigan in July, building on studies he began in his 2011 doctoral thesis.
"The idea is simple: The shareholders have the votes," and anyone who wants to be CEO, or a board member, knows he has to make them happy, not just by producing maximum profits for his company, but by not damaging prospects for its competitors who share the same owners even when that means squeezing customers, through higher prices.
"Common ownership pushes product markets toward monopolistic outcomes," Azar wrote in his paper on U.S. airlines. He notes that the seven institutions that control 60 percent of United Airlines in 2013 to 2015 also owned about a quarter of rivals Delta and Southwest. Why, he asks, would they want their companies to cut prices against each other?
Studying the 2011 takeover of the former Barclays index-funds group by BlackRock, Azar estimated ticket prices rose by 60 cents per $100 because of the owners' merger. More generally, he estimates that prices along U.S. routes owned by major publicly traded airlines are 3 percent to 11 percent higher because they have common owners.
Similarly, big-bank customers in California, New York, and New Jersey pay much higher fees than the mostly regional-bank customers in Kansas or Nebraska even though there is a lot more competition in the high-fee states. That is most easily explained by bank bosses' need to keep profits flowing to their largest investors, who are the same for Citigroup, JPMorgan, and Bank of America, Azar writes.
Reviewing pricing data and checking alternate explanations, Azar concludes that "index fund growth causes higher prices for banking products." He says the U.S. antimonopoly police needs to study the impact of massive common ownership before taking "bold action."
Joint control over major companies by few large U.S. investment managers "can help explain fundamental economic puzzles, including why corporate executives are rewarded for industry performance" instead of just their own, "why corporations have not used recent high profits to expand output and employment, and why economic inequality has risen," writes Einer Elhauge, professor at Harvard Law School, in an essay on "Horizontal Shareholding" in the Harvard Law Review that cites Azar's work at length.
CVS and Walgreen's, Apple and Microsoft - all the big, public companies we think of as competitors - are actually owned largely by the same companies, especially BlackRock, Vanguard, State Street, and Fidelity Investments, Elhauge notes.
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