Are Index Funds Too Soft on CEOs?

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.

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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.

The claim goes like this: Because index-fund managements haven't pushed CEOs to attack their rivals more aggressively, and moved to oust those who do not comply, CEOs have taken a different approach, by behaving as if they are in cartels. Why fight other companies when all sides can benefit by playing nicely? Thus, corporate managements have not emphasized growing their slice of the industry pie, but rather making the whole pie larger, through semimonopolistic behavior that gives the industry a pricing umbrella.

In this tale, index funds remain the bad guys, for a completely different reason. Now they are to be blamed not for reducing shareholder value, but for increasing share prices. Because of the inactions of index funds, corporations are not competing vigorously enough, which enables them to overcharge, which boosts their profit margins and share prices--but at a social cost. Consumers are paying too much for the goods and services they consume.

Martin Schmalz, assistant professor at the University of Michigan, explains:

"We make a concerted effort not to refer to the phenomenon we study [in this paper] as 'collusion'. That is not what we have in mind at all. "The whole trick of common ownership is that you need no collusion for higher prices to obtain, because common ownership reduces the incentives to compete in the first place. The reason is that competing less aggressively can be in the unilateral interest of each firm in isolation. When the most important shareholders have reduced interests in their firms competing, why would the firms still compete?"

In other words, neither index funds nor CEOs have actively conspired. The problem instead has been neglect.

In the absence of further discussion--which would require a great deal more space, and yield little but questions--let's assume that Schmalz has the story right and that the latest academic hypothesis is the correct one. Are index funds to blame?

Assessing Guilt I don't see how. After all, nearly all forms of investment management lead to giving CEOs great freedom. True, portfolio managers who market themselves as being "activist" treat CEOs differently than do those who vote on behalf of index funds. Activists seek seats on the boards, badger corporations to divest themselves of subsidiaries, and insist the firm put itself up for sale. Index funds only rarely take such actions.

But activist funds are rare indeed, and other investment managers behave much more like index funds. Certainly, actively managed mutual funds do. The vast majority of them vote with their feet, not their proxy ballots. Midsized-to-large fund companies own thousands of stock positions. They have neither the time nor motivation to hound all those corporate managements, or even more than a tiny fraction of them. Whichever way index funds end up voting their proxies, so too will the bulk trillions of dollars held by actively run mutual funds.

The same precept holds for stock market's other major parties. The giant pension funds have huge, diffuse portfolios, as do sovereign-wealth funds. Perhaps some of the underlying managers that they hire to run segments of their assets are activist, but the funds themselves are not. (They may lobby companies for social changes, for example to implement green policies, but that is a different matter.)

And that brings us to … retail investors who own equities directly. I am in that crowd, holding a few stocks along with my core mutual funds. I confess to having never read through any proxy statement that I have received from a company, or indeed voting on that action. Perhaps I am radically different than the norm, but I doubt it.

In summary, the new academic hypothesis that professional investment managers have permitted U.S. businesses to engage in semimonopolistic prices is intriguing. Perhaps that notion will eventually be accepted as being true. Even if so, it's difficult to see how index funds are at fault. If they had never been born, so that the leading stock mutual funds today were like those of the 1980s, diversified offerings from American Funds and Fidelity and T. Rowe Price, corporate governance would likely be similar. And the academic community would be raising the same questions about whether CEOs have overstepped their bounds.

Verdict: Not guilty. Whatever sins index funds have committed, they have been joined while doing so by many, many others.

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.