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Are Index Funds Too Soft on CEOs?

Let's look at the argument that indexers fail with corporate governance.

John Rekenthaler, 08/15/2017

The Third Accusation
Friday's column absolved index funds completely from one alleged crime, and largely from another. They have not inflated the level of the overall stock market. Nor have index funds substantially distorted prices within the marketplace. Yes, index-fund inflows are invested unequally, such that those companies held by the S&P 500 have received massive proceeds that other firms have not. But the effects have been minor, because when index funds exit, trillions of actively managed dollars remain to fill the gap.

(Consider, for example, First Solar FSLR, dropped from the S&P 500 in March, after the company lowered its 2017 profit forecast. The company's shares took a two-month beating but recovered when First Solar raised its estimates. The stock is now 50% higher than when Standard & Poor's announced it would be dropping the company from the S&P 500. Devastating, that news was not.)

A third allegation, that of poor corporate governance, remains on the docket.

Are Shareholder Values Too Low?
This criticism is long-standing, but its details have changed. Once the charge was that by failing to hold CEOs' feet to the fire, as activist managers did, index funds harmed their shareholders' interests. Without shareholders hounding their actions and disciplining them via proxy statements, corporate managements took the paths that were easiest for them and their employees. This cost companies profits and, thus, lowered shareholder values.

This argument had the support of both Wall Street and finance professors. Until quite recently (more on that shortly), the consensus of both the Street and the academic community was that if left unchecked, CEOs would sacrifice profitability in order to build empires. The bigger their companies, the more important that made them. Their employees would also be happy, because the company would be adding rather than subtracting jobs. So the task of outside shareholders was to nag, nag, nag, so that the company would divest, divest, divest.

Naturally, active portfolio managers agreed with this thesis, as it portrayed them as the unsung heroes of the stock market. They might be loud, they might be annoying, and they might charge high fees for their services, but they were on the side of the angels. Their individual, selfish acts encouraged CEOs to become better actors, which worked to the benefit of investors everywhere. The stock market was aided by an invisible hand.

Unfortunately for those who advocated it, that theory had a major problem. According to its underlying logic, CEOs would get progressively worse at their jobs as index funds became larger, because that meant that the companies would increasingly be owned by shareholders who would not sell their stock no matter how badly the company behaved. Thus, corporate profit margins would decrease further, along with shareholder value.

Or Too High?
So much for that prediction. Each year, U.S. corporate profits exceed last year's mark. The challenge for those who study corporate managements' behavior has become not to explain why CEOs underperform and how they can do better, but rather to explain why they have been so very successful. In fact, states the latest academic argument, CEOs have been too successful.

is vice president of research for Morningstar.

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