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Rekenthaler Report

The Misplaced Attack on Index Funds

Sheep, sloths, and gorillas.

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The Charges

The Atlantic delivered the latest of many, many salvos against index funds. In "Could Index Funds Be 'Worse Than Marxism'?" (never again accuse me of click baiting), staff writer Annie Lowrey lodges three concerns about the spectacular growth in indexing. According to her article, the practice potentially creates:

1) Investment Sheep
Indexing reduces individuality among stock returns, by making equities likelier to rise and fall in unison.

2) Corporate Sloths
Indexing discourages corporate competitiveness, because indexers don't encourage Coca-Cola (KO) to devour PepsiCo (PEP). Rather, indexers would prefer that the two companies share a duopoly.

3) Shareholder Gorillas
Indexers carry too much influence with corporate managements.

These are familiar items; Lowrey resurfaces existing claims. However, as Lowrey has no investment services to sell--many previous attacks on indexing having come from embittered active managers--her article serves a useful purpose. It summarizes the doubts that reasonable people might have about index investing.

In Response

My reaction to each allegation:

1) Investment Sheep
Intuition suggests that if more investors own every stock in the S&P 500, in direct proportion to the benchmark, then those securities would increasingly tend to trade together. Tellingly, though, Lowrey's article does not provide such evidence; rather, it cites the behavior of a commodity-futures index. The suspicion thus arises that U.S. equity returns have not, in fact, supported the assertion.

Indeed they have not. According to data compiled by Amundi Research, the correlation among the S&P 500's stocks has remained steady since 1974, when indexing barely existed. To be sure, the statistic has fluctuated widely through the decades, but with no discernible pattern. The periods of highest correlation came during the 1980s and following the 2009 global financial crisis. In recent years, the correlation has been near its historic norm.

While that chart concludes in 2019, a more recent one (based on a somewhat different calculation method) places trailing three-month S&P 500 correlations near their five-year lows. They are well above their 2016 levels, even though index funds have since grown their market share of U.S. large-company blend assets, from 39% in January 2016 to 52% today.

When intuition conflicts with the data, best to revise the intuition. (In fairness to Lowrey, she calls the next accusation a "far bigger concern.")

2) Corporate Sloths
This argument was sparked by an academic article, which found the more that airline shares became owned by institutions that invested across the industry, rather than in one or two favorites--a situation known as common ownership--the likelier the airlines were to raise fares. Presumably, this occurred because shareholders who own an entire industry would prefer that their companies compete only gently, so as not to engage in destructive price wars.

That belief, too, is supported by common sense. It's logical that those who invest in a single company would view that firm's attempt to disrupt the marketplace more favorably than those own shares in all the industry's businesses. However, the paper's approach is complex--to the point where other researchers, using a similar data set, reached the opposite conclusion--and the industry sample size is 1. It's fair to say that this hypothesis remains unproven.

(In addition, if corporate managers are so guided by their institutional owners, their cues must come as winks and nods. No index-fund manager will explicitly tell CEOs to stop attempting to grow their companies' market shares for the benefit for the rest of the industry.)

3) Shareholder Gorilla
This objection comes in two flavors, each of which undermines the other.

One criticism is that index funds are unduly powerful. Lowrey quotes a Harvard professor, John Coates, who notes that Vanguard, BlackRock, and State Street collectively hold an average of 17% of large U.S. companies--a figure that understates indexers' power because many shareholders do not vote. Effectively, says Coates, the three firms control 25% of the vote in company elections.

The other contention is that indexers are unduly passive. In theory, they weigh 800 pounds. In practice, they are the Stay Puft Marshmallow Man--seemingly enormous but in reality empty lightweights. (In Ghostbusters, the Stay Puft Man was a surprisingly formidable foe, but never mind that detail.) They don't exercise their corporate responsibilities diligently. As a result, today's CEOs have too much freedom. Their feet should be held more firmly to the fire.

The True Culprit

These worries are speculations, not observations. Either the financial markets are acting as they always have, as with stock correlations, or other reasons can be offered for their changes. For example, Wall Street analysts have long criticized companies for overinvesting during booms, arguing instead that they should improve margins by raising prices. Perhaps airline CEOs finally listened.

That doesn't mean that these hypotheses aren't worth monitoring. The bigger point, though, is that they apply to all forms of investment management. Whether they invest passively or actively, trillion-dollar organizations hold everything. They offer hundreds of funds (if not thousands, counting separate accounts for their institutional clients), managed by dozens of portfolio managers. Inevitably, they hold both Coca-Cola and PepsiCo, and in very large amounts.

In short, the effects attributed to indexing owe to the industry's increased concentration. The leading investment firms have continued to gain market share. As a result, they control ever-larger portions of publicly traded U.S. stocks. Had indexing never been invented, with U.S. equity assets instead concentrated in the active hands of Fidelity, American Funds, and Putnam, the same concerns would exist. Articles would warn, and regulators would fret.

Whether too few people currently exert too much stock market control is a question worth pondering. If problems do exist, however, they arise from money managers' bulk rather than their investment tactics.

 

John Rekenthaler (john.rekenthaler@morningstar.com) 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.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.