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The Latest Salvo Against Indexing

They lead to lazy CEOs and fat-cat profits.

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 That is why "Common Ownership, Competition, and Top Management Incentives," an as-yet unpublished paper by four professors (Miguel Anton, Florian Ederer, Mireia Gine, and Martin Schmalz), has attracted so much media attention.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.
  • 4. Yes, corporations can be too profitable, as outlined by The Economist in last year's "Too Much of a Good Thing." States the article, "High profits can be a sign of sickness. They can signal the existence of firms more adept at siphoning wealth off than creating it afresh, such as those that exploit monopolies. If companies capture more profits than they can spend, it can lead to a shortfall of demand." Consumers will overpay for their goods, and income will be spread unequally and inefficiently.

In Response To address those four points, in reverse order:

  • 4. Excess Profitability. The irony is deep here: Until very recently, Wall Street argued that the chief flaw with American corporate managements was that they sought to build empires by boosting their revenues (and employee counts) rather than to emphasize profits. This criticism was joined by most academic researchers and by the business press, which argued vociferously that what was best for shareholders was best for America. By that account, index funds are heroes rather than villains. Assuming that index funds behaved as the professors described, that means that indexers were able to accomplish what decades worth of active managers could not: getting CEOs to maximize shareholder value. It appears that not only retail investors should worship at the statue of St. Jack, The Wall Street Journal's op-ed writers should genuflect, as well. Not that I share Wall Street's opinions, either as held previously or today. Quite the contrary--it seems to me that global economic trends outweigh the collective failures or successes of corporate executives' decisions, and that those who argue the importance of the latter do so because that subject is simpler than addressing the full truth.
  • 3. Inattention to Executive Compensation. The professors report that BlackRock, Vanguard, and Fidelity voted yes on executive-compensation proxies "at least 96% of the time." (That "at least" is puzzling. Either the figure is 96%, or it is higher than 96%, in which case it could be reported at the higher amount.) Well, I can't argue the point; indexers are soft on executive-pay packages. Then again, the approval rate for all other shareholders, which represent 75% of stock-market assets, is 88%. If three fourths of shareholders ratify corporate proxies close to 90% of the time, and the remaining fourth does so 96% of the time, how disruptive can that latter group be? Is that modest difference, from a minority bloc of investors, truly enough to cause a large change in CEO pay schemes--and an even larger change in the overall economy? The professors answer both questions in the affirmative. The first is supported by multiple regressions that show circumstantial evidence that higher passive ownership is linked to higher executive pay. Maybe--although any number of other factors could be at work. The second question, that of the effect on the overall economy, is a much longer reach. I will require significantly more convincing on that point.
  • 2. Coercive Behavior. This point I do not understand. As a shareholder, I want my company to maximize its profits, so that its stock price rises to the highest possible level. (I do confess to the fifth deadly sin, although not the other six.) If it can do so by colluding with other organizations so as to create an industry pricing umbrella, that is fine. Whatever works. I don't judge how CEOs go about their jobs; I judge the results. Which makes me, as far as I can tell, the same as a rational active investment manager, and the same as index-fund managers. I grant that I may be missing something here--because the professors are quite certain of this part of their argument, and they are bright people--but I haven't yet figured out why active managers would be so penny wise and pound foolish as to wish for the companies they own to be fiercely competitive, even if that meant damaging the industry's overall prospects. That math does not appear to work in their favor.
  • 1. The Basket Mindset. No argument here. Without question, index-fund managers are happiest when all boats are floating. Such is likely the case for most large-company stock fund managers, who hold dozens if not hundreds of positions, so this point doesn't strike me as particularly profound. To the extent that it holds, the professors' argument would seem to apply to all forms of professional investment management rather than merely the species of indexing. However, the claim that index managers care about industry fortunes, not the success of given companies, is surely correct.

More to Come You will no doubt be hearing further about this topic, if not in this column, then elsewhere. The two biggest investment stories in the United States today are the extraordinarily high level of corporate profits and the boom in indexing. It is natural that people will perceive a connection between the two. So far, though, the evidence does not seem terribly compelling.

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.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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