The Pros and Cons of Index Investing

An academic paper has recently ignited the debate over the value of index investing

John Rekenthaler 25 September, 2017 | 11:06AM

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 0.8% for actively managed funds' expense ratios.

An academic paper on the topic by four professors, Miguel Anton, Florian Ederer, Mireia Gine, and Martin Schmalz, has attracted much media attention for joining the fierce debate over passive investing.

The paper is entitled Common Ownership, Competition, and Top Management Incentives,and originates from the European Corporate Governance Institute and the University of Michigan.

The Case Against and For Index Funds

Charge One: Because index funds own substantially the entire marketplace, their managers don't care whether a particular company is successful

Response: Index-fund managers are happiest when all boats are floating. Such is likely to be 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. 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.

Charge Two: Index-fund managers don’t want full competition

Index-fund managers don't want their companies battling it out, so that some companies win, others lose, and consumers benefit from the competition. They seek coercive behaviour, wherein all the members of an industry quietly work together, so that overall industry profit margins are higher than they would otherwise be.

Response: As a shareholder, I want my company to maximise its profits, so that its stock price rises to the highest possible level. If it can do so by colluding with other organisations so to create an industry pricing umbrella, that is fine. I don't judge how CEOs go about their jobs; I judge the results, which makes me the same as a rational active investment manager and the same as index-fund managers.

Charge Three: Index-fund managers don't bother challenging 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 with happy and complacent CEOs.

The professors report that BlackRock, Vanguard, and Fidelity voted yes on executive-compensation proxies "at least 96% of the time".

Response: The approval rate for all other shareholders, which represent 75% of stock market assets, is 88%. If three-quarters 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?

The professors agree: circumstantial evidence shows that higher passive ownership is linked to higher executive pay. That may be correct, although any number of other factors could be at work.

Charge Four: Corporations can be too profitable

As outlined by The Economist in an 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.

Response: 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 emphasise 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 maximise shareholder value.

Booming Profits and and Booming Indexing

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.

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, but the evidence so far 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. While Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

John Rekenthaler

John Rekenthaler  John Rekenthaler is vice president of research for Morningstar.

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