For the First Time, Index Funds Face Federal Scrutiny

The Concerns

Index fund detractors have long urged regulators to restrain passive investment managers. Most such complaints were groundless—attacks from investment organizations that had lost market share to indexers and hoped the government would accomplish what they could not. (That those firms otherwise abhorred regulatory actions did not strengthen their credibility.)

Some critiques, however, could not so easily be dismissed. In 2014, three academics published the initial draft of a paper entitled “Anticompetitive Effects of Common Ownership,” which argued that index funds hurt consumers by tacitly encouraging corporate managers to avoid price wars. Since indexers own every stock, they do not benefit when one company captures business from another. Rather, they fare best when everybody wins. Fat and happy industries make for fat and happy index funds. However, consumers become thinner and angrier.

That claim is difficult to prove, as there are no “smoking guns” of conversations. The authors were forced instead to rely on complex correlation studies that nudged the data to confess. (I was unconvinced.) That said, the paper was both thorough and published by nonpartisan sources. It was therefore influential.

Four years later, Harvard Law Professor John Coates IV criticized index fund practices from a different angle. For Coates, the issue is not the specific advice that index fund managers give to corporate chiefs, which he does not profess to know, but rather the fact that they can give it at all. Too much power rests in too few hands. (Said Coates, “I think the world of Larry Fink, but I’m not sure I want him to be my emperor.”) With that contention, even Jack Bogle agreed, writing that “such concentration [by index providers]” does not “serve the national interest.”

But if federal control is required, which body can provide it? Antitrust legislation applies to corporations—not the organizations that invest in them. The SEC doesn’t appear to have jurisdiction either. Nothing within the Investment Company Act of 1940, or other related statutes, prohibits investment companies from becoming too large and successful, as long as they obey the rules. It seemed that indexing would continue its inexorable rise, free from interference.

Enter the FDIC

Until now. On Tuesday, The Wall Street Journal reported that the FDIC is discussing measures that would curb the power of indexers. According to the article, the FDIC’s board shares “bipartisan” concerns that index fund managers are justifying the fears of Coates and Bogle by exerting undue influence on the banks the agency oversees.

Among the board’s proposals is an investment moratorium, which would immediately prevent any organization that owns more than 10% of a bank’s shares—in practice, that means Vanguard and BlackRock BLK—from buying additional shares until the FDIC settles upon its permanent policy. Presumably, that policy would add specific prescriptions to the current, very general requirement that when investors exceed the 10% threshold, they must do so “passively.”

Muddled Thinking

I have three comments. First, although I had not envisioned that the FDIC would become involved, the agency’s interest is logical. Banks are abnormally vulnerable both to contagion—if a major auto manufacturer shuts its doors, people buy other cars, but if a major bank does the same, it may spark a general panic—and to hostile shareholders. As Bloomberg’s Matt Levine notes, attacks from short-sellers have never bankrupted a nonfinancial company. But they have contributed to banking fatalities.

That said, the FDIC’s comments have strengthened my suspicion that although many believe the giant index funds must be causing trouble, none can say how. The anticompetitive effects paper blamed indexers for being too hands-off. When they should have been encouraging CEOs to seize market share, they stayed silent, preferring that the industry remain a clandestine cartel. However, states the Journal article, Republicans on the FDIC board have the opposite worry: that indexers say too much, by advancing liberal agendas. The Democrats echo Coates and Bogle by decrying indexers’ “unduly large” sway on the economy.

In short, although the agency is correct to consider the issue, I am not sure that its solutions will be apt.

My second thought is that the moratorium proposal is a bit strange. If Vanguard and BlackRock index funds remain popular, as seems likely, then their incoming assets could not be invested in additional bank shares? Those funds would then become “almost indexes,” holding proportional amounts of US companies, save only for banks? Hmmm. That not only smacks of regulatory overreach but will also displease all relevant parties: fund managers, shareholders, and bank executives. Nor does it seem necessary, as index-fund ownership increases gradually. Surely the FDIC can establish its permanent policy within the next couple of years.

A Sound Idea

Third and finally, as suggested by my colleague Jeff Ptak, the likeliest consequence of the FDIC’s investigation is to hasten a trend that has already begun, from index fund companies voting their investors’ interests to their investors voting their proportionate shares directly. (I wrote about that development in 2021 and again earlier this year.) So far, that movement has involved institutional investors only. But logically, it should also be extended to individual shareholders.

After all, investors in mutual funds and exchange-traded funds are the true owners of the underlying stocks. It is their money on the line, not that of the fund manager. Vanguard, BlackRock, and others are merely the hired help. As caretakers, those firms should neither vote on corporate proposals nor advise executives on how to run their businesses. Today, it is true, those investment managers speak for shareholders. But the time has come for that practice to cease. Technological improvements now permit individual owners to express their views through voting. The regulations that govern proxy votes should change along with them to reflect those improvements.

(To achieve adoption, this process would need to occur automatically, with artificial intelligence routines substituting for the investor’s responsibility. The routine’s decisions would be based on a conversation conducted with the shareholder. Of course, investors could choose to override the AI’s vote, should they so desire, but in practice they rarely would, given the effort involved.)

Summary

Initially, the Journal article puzzled me. I did not understand why the FDIC got involved and was confused by the agency’s approach. In some ways, my confusion persists. However, to the extent that the FDIC’s intrusion accelerates the process of empowering fund investors, while also relieving indexers from duties they should not attempt, all the better! That outcome would be a double victory.