Jack Bogle, the founder of Vanguard, in 2012.Photograph by Jessica Kourkounis/The New York Times/Redux
If you have so much as tiptoed into the arena of personal finance over the past few decades, you will have heard about the virtues of passive investing. The argument goes like this: the stock market will outperform other investments over the long term, yet no individual is in a position to outsmart the market as a whole. So the best way to reap the rewards of investing in stocks with minimal risk is to put your money in a fund that tracks the performance of some broad, indexed measure of the market, such as the S. & P. 500. If you have an I.R.A. or a 401(k), there is a reasonably good chance that some of your money is invested this way; low management fees make index funds an attractive option.
Until the last part of the twentieth century, anyone who wanted to invest in the stock market had to buy individual stocks. But in the early nineteen-seventies, academic models for how to index stocks began to gain traction in the media, which encouraged Jack Bogle, the founder of Vanguard, to introduce the first indexed mutual fund, in 1975. The approach grew in popularity thereafter, and sharply so between 2000 and 2014, when the amount of money invested in index mutual funds more than quintupled. The more recent rise of exchange-traded funds (E.T.F.s), which are indexed to a broad market or a sector but trade daily like stocks, has accelerated the trend.
Depending on how you count, as many as twenty per cent of stocks are now owned by indexed funds. When you factor in “closet indexing”—when individual or institutional investors pursue indexing strategies without declaring them—the proportion of passive investors is higher still. As the number continues to rise, some scholars, economists, and investment professionals have begun to wonder anew how high it can go, and whether, as passive investing grows, it is having harmful effects on the economy as a whole.
It stands to reason that beyond some threshold, a market that has more passive than active investors will behave differently than markets have in the past. One way to think about this is to imagine that investment decisions are increasingly on autopilot: more and more money will pour into a set of firms largely independent of the considerations that have traditionally guided investors, such as supply, demand, management performance, growth potential, or broader economic factors.
In January, three business-school professors—one from the University of Washington and two from Washington University, in St. Louis—drafteda paperexamining the effects of passive investing on companies that rely heavily on commodities. The authors focussed specifically on the futures and derivatives markets, studying agriculture, energy, and metals businesses, among others. While they acknowledge that their research is preliminary, they conclude that passive investing sends distorted signals about commodity prices. The firms they studied experienced disruptions in cash flow, production costs, inventory, and return on assets. In an e-mail, one of the researchers, Jonathan Brogaard, of the University of Washington, cited the theoretical example of a chocolate manufacturer that buys lots of cocoa beans. Historically, the price of beans on futures markets has reflected the demand for cocoa. But the relatively recent entry of passive investors into such markets distorts the demand signal that the price sends, because they’re buying futures without reference to those kinds of traditional considerations. This can make it harder for the manufacturer to predict demand, potentially driving up costs.
It’s not hard to imagine large-scale passive investments warping the stock market in similar ways. Typically, stocks are indexed by market capitalization—the value of a firm’s share price times the number of shares—from highest to lowest. A market with more passive investors than active ones will continue to push money into the largest firms, whether these companies are actually performing strongly or not.
Timothy O’Neill, the global co-head of Goldman Sachs’ investment-management division, told me that essentially every new indexed dollar goes to the same places as previous dollars did. This “guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up. There’s no valuation or other parameters around that decision,” he said. O’Neill fears that the result will be a “bubble machine”—a winner-take-all system that inflates already large companies, blind to whether they’re actually selling more widgets or generating bigger profits. Such effects already exist today, of course, but the market is able to rely on active investors to counteract them. The fewer active investors there are, however, the harder counteraction will be. (As an investment bank, Goldman Sachs profits from management fees, though it also sells E.T.F.s.)
Another group of scholars is concerned that index funds can also hurt consumers more directly. In astudyof banking ownership and competition, which was published in January, two University of Michigan business-school professors and a management consultant demonstrated that banks whose shares are often packaged in index funds tend to offer higher fees and rates for such services as account maintenance and deposit certificates than banks whose stocks are rarely or never included in index funds. The reason, the authors surmise, is that ownership by index funds gives banks an incentive to behave more as if they have a common owner. The reduced sense of competition leads the banks to charge consumers more.
In adiscussion paperwritten last year, Einer Elhauge, a law professor at Harvard University, found that index-fund ownership was having a similar effect in the airline industry, where nearly eighty per cent of all stocks are owned by a handful of investors. Elhauge argues that institutional investors with an emphasis on index funds, such as Vanguard and Fidelity, are playing an outsized role in the sector, and that their rapid adoption is accelerating ownership concentration, resulting in higher prices for travellers. “Alone, index funds are not enough, but they are growing like gangbusters,” he explained in an interview.
Everyone agrees that the rapid growth of passive investing is a novel enough phenomenon that its effects require greater study. And to the extent that policy-makers perceive it to be a problem, some relatively painless solutions exist. The analysis from O’Neill, of Goldman Sachs, suggests that the problem is not indexing or passive investing per se; he considers indexing to be one of many financial innovations that creates value but can be pushed too far. Instead, he suggests finding ways to index stocks that rely on some other factor besides sheer market capitalization (for example, using some measurement of a stock’s value, such as a price-to-earnings ratio). Elhauge, for his part, thinks that existing antitrust law could be used to compel the large airline shareholders to alter their strategies in ways that shrink their influence. The investors could, for example, be limited to holdings in only one company per sector, or agree to purchase only non-voting stock, which would leave them with less impact on company management.
Given the cost-effectiveness of the strategy, individual investors will not abandon index funds any time soon. But perhaps we shouldn’t be shocked if an investment method that encourages us to use as little discernment as possible ends up being too good to be true. If passive investing continues to be one of the fastest-growing trends in finance, the concerns will not disappear, and the market may have to adapt to accommodate them.
