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The Latest Salvo Against Indexing

They lead to lazy CEOs and fat-cat profits.

John Rekenthaler, 09/19/2017

From the Beginning
This column is a companion to August's "Are Index Funds Too Soft on CEOs?" That article began in medias res, but unlike a proper epic, it never got around to the beginning. This time I will take the matter in proper linear order, along the way offering additional thoughts, as I have had another month to think through the issue.

To start: There will always be arguments against indexing. If passive funds never existed, traditional fund managers would be collecting an additional $40 billion in annual fees (roughly speaking, $5 trillion held by index mutual funds and exchange-traded funds times 0.80% for actively managed funds' expense ratios). When $40 billion are put into play, people fight.

If those people are the direct competition, they can reliably be ignored. I have never heard a sound argument against indexing advanced by active managers. Indeed, I can extend that lesson: I have never heard a sound argument against any investment practice coming from those would profit if they are believed.

(Which calls into question the standard premise of economists that money is the supreme motivator. Active investment managers have a huge financial incentive to discredit indexing, but their efforts have been woefully lax. Only a handful of active managers, chief among them American Funds, have researched the subject. The rest simply wave their arms and chant bumper-sticker homilies.)

Academic research is a different matter, which most journalists understand. That is why "Common Ownership, Competition, and Top Management Incentives," an as-yet unpublished paper by four professors (Miguel Anton, Florian Ederer, Mireia Gine, and Martin Schmalz), has attracted so much media attention. The paper's claims underlie a host of recent strikes against indexing from the popular press, for example, "The Worst-Case Scenario for Passive Investing," by Bloomberg columnist Stephen Gandel, or "Vanguard Group is America's new landlord," published on philly.com.

The Case Against
The charges are as follows:

1. Because index funds own substantially the entire marketplace, their managers don't care whether any particular company is successful.

2. Instead, they care about industry fortunes. Index-fund managers don't want their companies battling until they are red in the claw, so that some companies win, others lose, and consumers benefit from the competition. They seek coercive behavior, wherein all the members of an industry quietly work together, so that overall industry profit margins are higher than they would otherwise be.

3. Consequently, index-fund managers don't bother with executive-compensation schemes. Conventional fund managers, who want their companies to dominate even if that damages the fortunes of other firms in the industry, desire hungry, motivated corporate managements, and they spend resources making certain CEOs deserve their pay. In contrast, index-fund managers are fine if their CEOs are fat, happy, and complacent. Let consumers burn--the industry can count its collective profits while fiddling.

is vice president of research for Morningstar.

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