Index Funds Are Good Corporate Governors: Who Knew?

Passive in Name Among index funds' alleged sins, poor corporate governance is the most plausible.

Accusations that index funds distort the stock market's behavior do not convince, being merely the latest in a long line of excuses offered by lagging active managers. (Long before index funds prospered, active managers found ways to explain how the market erred in underpricing their holdings.)

Also suspect are claims that index-fund inflows may cause a stock-market "bubble." What does indexing have to do with it? A dollar invested into an index fund that buys U.S. stocks is the same as a dollar invested in an actively run fund that buys U.S. stocks. What matters is not the vehicle, but rather the amount. And that suggests no danger. In 2015, net flows into U.S. equity mutual funds and exchange-traded funds were slightly negative. Puny bubble.

That index funds could be indifferent corporate governors, however, is credible. Although it's true that index funds, as with any stock owner, benefit when companies are run better, and generate higher profits for their shareholders, they do hold a great many securities. There is only so much governance energy to be expended. Also, it's not as if index funds can dump a stock if corporate managements fail to co-operate. They are stuck with what they own.

Active in Deed That story sounds reasonable, but, write three business-school professors, it is not correct. According to them, the growth of indexing has improved corporate governance. Their paper has not yet been officially published (it's scheduled for the Journal of Financial Economics) but already has won two research awards (neat trick, that).

As one of the authors, Ian Appel, writes while summarizing the article for the Harvard Business Review, the subject of corporate governance traditionally has been disputed through logic. Active managers invoke the principles that indexers cannot exit their positions, and that indexes lack motivation to force changes, because index funds are paid to match the market, not to achieve absolute gains. Vanguard CEO Bill McNabb responds with the indexer's perspective: "We're going to hold your stock if we like you. And if we don't. We're going to hold your stock when everyone else is piling in. And when everyone else is running for the exits. That is precisely why we care so much about good governance."

The authors take a different approach. Rather than deduce how many teeth are in the horse's mouth, they attempt to pry it open and count. Specifically, they isolate those stocks that make up the bottom of the Russell 1000 Index and the top of the Russell 2000 Index. The first group, in general, is owned less by index funds than is the second group. (The authors explained to me why this is so--can you guess?) The authors then tested to see whether there were disparities between the two.

There were. The authors found that companies with higher passive ownership were likelier to:

1. boost the number of independent directors on their corporate boards;
2. remove takeover defenses, such as poison pills;
3. have equal voting rights, rather than an unequal dual-class structure.

Appel summarized:

Our findings suggest that passive institutions influence firm governance primarily through the power of their voice. An increase in passive ownership is associated with a decline in support for management proposals and a boost in support for shareholder proposals. Basically, when passive funds make up a larger percentage of the ownership, management appears to be confronted with a more contentious shareholder base.

So much for passive investors being passive.

Another Point for Gryffindor By my count, the debate score is now, approximately, Indexing 79, Active Management 2.

Active management will not expire, any more than people can die by holding their breath. (Try, if you feel adventuresome.) Should indexing's market share become extremely high--well above today's level--then stocks will no longer be thoroughly researched and prices will be assigned less rationally. The top active managers will once again reliably beat index funds and will therefore begin to attract assets. Indexing will exhale, and active management will revive.

But there is surviving, and there is thriving. If active stock management wishes for the latter, then it should talk less and study more. (The two debate points that I gave active management were for its initial attempts at proving its case quantitatively, as opposed to its usual tactic of appealing to its listeners' sensibilities.) Sooner or later, somebody will cut through the posturing by running the numbers. Better to get out ahead of those results, rather than be caught scrambling after they are published.

The authors do offer one consolation for active management: More assets in index funds means a larger shareholder-friendly voting bloc, which should ease the task of activist fund managers. Many have predicted that indexing's growth will present opportunities for actively run funds. So far, so little. But if the authors are to be believed, then activist funds may prove to be a happy exception. Unfortunately, most of them are hedge funds, not registered mutual funds.

Bad Attitude A friend who is an investment advisor timed his energy trades almost perfectly, adding to his customers' portfolios within two days of oil's Jan. 20 bottom. It's mostly sheer, dumb luck, of course, but he does credit a bit of success to his contrarian timing signal. He monitors prominent Wall Street strategists who forecast commodity prices, and he seeks a prediction that is:

1. for the short term (less than 12 months);
2. dramatic (less than half or more than double the current price);
3. following a recent price trend.

(He awards a bonus point if the prediction comes from Goldman Sachs. To which I would add, five bonus points if the source is Jim Cramer.)

And people say Wall Street forecasts are useless...

Spam, Spam, Spam, and Morningstar If you received a batch of emails from Morningstar late Sunday night through early Monday morning, you are not alone. Sorry about that. All seems to be sorted out now.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.