Who's afraid of index funds? (Update)
Pro-investor but anti-consumer, and risky, Euro scholars say
Here in Philadelphia, where we've watched Vanguard Group grow for 40 years to $3.5 trillion in assets around 12,000 local staff, we are used to seeing Vanguard-style low-fee, autopiloted, indexed mutual funds and related ETFs as a positive innovation that has helped savers retire with more money. American investors have voted with their dollars to make Vanguard the fund industry leader.
Success brings scrutiny. In a spate of recent research papers, economists and other profs examining America's Big Three index fund purveyors -- BlackRock, Vanguard and State Street -- say they have found, not just a cheap way for investors to try to squeeze profits from securities markets, but threats to capitalism as we know it. Vanguard's John Woerth responds to key arguments.
1) "HIDDEN POWER of the Big Three?," a working paper posted by political economist Jan Fichter and two colleagues at the University of Amsterdam, says the Big Three "are arguably exerting hidden power" by backing management in most shareholder disputes, benefitting from anti-competitive corporate behavior that enriches companies by driving up consumer prices, and threatening "systemic risk" to the financial system by "herding" shareholders into narrowly concentrated investments.
The paper notes that BlackRock holds at least 5% -- a big voice -- of more than 3,600 companies worldwide, and more than 10% of 375. Vanguard isn't far behind, with 5%+ of more than 2,600 companies and over 10% of 163, mostly in the U.S, where there are total of around 3,900 publicly-listed companies. Together with State Street they would form the largest owner in 438 of the 500 biggest U.S. companies.
The authors stop short of showing actual collusion; they do quote both BlackRock and Vanguard officials talking about the many private meetings they hold with corporate managers and the pressure they wield as shareholders' agents.
On that basis, large index-fund ownership gives investors the "private benefit" of "diversified low-cost investment," but also "reduce(s) product market competition, and thus has significant hidden social costs," Fichtner finds.
Citing Gerald F. Davis' 2008 paper, "A New Finance Capitalism?," and contemporary research by Wharton management prof Michael Useem, Fichter says the "concentrated ownership" of big mutual funds in U.S. companies has become "reminiscent of the early 20th Century system of finance capital when business was under the control of tycoons such as J.P. Morgan and J.D. Rockefeller."
With more than $4 trillion in total indexed investments, BlackRock, Vanguard and State Street together "represent the largest shareholder in 88 percent" of the S&P 500, Fichter notes.
BlackRock and Vanguard are meeting privately with company managers many hundreds of times a year. He notes their conservatism, which some have ascribed in part to the funds' unwillingness to upset corporate managers who are potential clients, and notes the fund giants' support for embattled DuPont Co. CEO Ellen Kullman in 2015, which I and others noted at the time.
"Today, Vanguard 500 Index Fund is the second largest mutual fund in the world with $256 billion in total assets. The only larger fund is its sister portfolio – Vanguard Total Stock Market Index Fund, with $466 billion in assets. In all, Vanguard is the industry's indexing leader and manages 250 index funds with $2.4 trillion in assets. As you (have) noted in your column, index funds have considerably improved outcomes for investors.
3) Fichter and his colleagues also cite two papers by a young Spain-based scholar, Jose Azar, and his collaborators at the University of Michigan and elsewhere, which find heavy index-fund ownership correlates with higher prices, both in U.S. national commercial banking, and in U.S. air travel -- two industries where most of the competitors are big, publicly-traded companies whose largest shareholders are BlackRock, Vanguard and State Street.
Fund managers don't need to engage in active collusion to pursue joint goals at the potential expense of consumers and others, Azar told me.
"Common ownership by asset managers predicts higher prices in airlines and banking," he said, citing papers he published with colleages at the University of Michigan in July, building on studies he began in his 2011 doctoral thesis.
"The idea is simple: the shareholders have the votes," and anyone who wants to be CEO, or a board member, knows he has to make them happy, not just by producing maximum profits for his company, but by not damaging prospects for its competitors who share the same owners -- even when that means squeezing customers, through higher prices.
"Common ownership pushes product markets toward monopolistic outcomes," Azar wrote in his paper on U.S. airlines. He notes that the seven institutions that control 60 percent of United Airlines in 2013-15 also owned about a quarter of rivals Delta and Southwest. Why, he asks, would they want their companies to cut prices against each other?
Indeed, studying the 2008 takeover of the former Barclays index-funds group by BlackRock, Azar estimated ticket prices rose by 60 cents per $100 because of the owners' merger. More generally, he estimates that prices along U.S. routes owned by major publicly-traded airlines are 3 percent to 11 percent higher becasue they have common owners.
Similarly, the fact that big-bank customers in California, New York and New Jersey pay much higher fees than the mostly regional-bank customers in Kansas or Nebraska -- even though there are a lot more banks, and competition, in the high-fee states -- is most easily explained by bank bosses' need to keep profits flowing to their largest investors, who are the same at Citigroup, JPMorgan and Bank of America, Azar writes.
Reviewing detailed pricing data and checking alternate explanations, Azar concludes that "index fund growth causes higher prices for banking products." He says the U.S. anti-monopoly police needs to study the impact of massive common ownership before taking "bold action."
4) VANGUARD ANSWERS: "With respect to systemic risk and herding, let's put indexing in perspective. In terms of total dollar market value, index strategies (mutual funds, separate accounts, pension funds, endowments etc.) constitute only 15% of equity market value and 10% of fixed income market value [not counting other indexed products, as Azar does.] "Further, only 5-10% of the daily trading volume can be attributed to index funds," Woerth told me.
"Index funds do not impose systemic risk and, additionally, size is a poor measure of systemic risk. Index funds are broadly diversified, unleveraged vehicles (covering all cap sizes and styles of the market) that are widely held by investors of all sizes and types.
"Vanguard funds continue to meet SEC and IRS diversification standards in terms of our current ownership levels of individual stocks.... There was an instance in the early 2000s when one of our index funds became extremely concentrated in its top four holdings, technically becoming non-diversified under SEC standards. Shareholders then approved our proposal to re-classify the funds as non-diversified; see release for more information."
5) SO WHAT? Are regulators concerned? Fichtner cites Andrew Haldane, a top official of the Bank of England, in this 2014 speech warning about the "age of asset management" increasing "investor herding" that can imbalance market cycles, leading to higher highs, and lower lows, representing "new systemic risk."
He also cites Federal Reserve Bank of New York economist Nicola Cetorelli's late 2014 report on the risks of indexed mutual funds lending lots of money on the securities they hold for investors -- though BlackRock says the risks aren't that bad.
Fichtner also quotes SEC commissioner Luis Aguilar asking if regulators, given "investor herding," pricing complications, and the resulting "systemic risk," "should consider curtailing the growth" of ETFs, a largely passive investment product. Read Aguilar's remarks here.
6) OH, THAT EXPLAINS IT: Joint control over major companies by a handful of large U.S. investment managers "can help explain fundamental economic puzzles, including why coprorate executives are rewarded for industry performance" instead of just their own, "why corporations have not used recent high profits to expand output and empolyment, and why economic inequality has risen," writes Einer Elhauge, professor at Harvard Law School, in an essay on "Horizontal Shareholding" in the Harvard Law Review that cites Azar's work at length.
CVS and Walgreen's, Apple and Microsoft -- all the big, public companies we think of as competitors are actually owned largely by the same companies, especially BlackRock, Vanguard, State Street, and Fidelity Investments, Elhauge notes.
BlackRock and Vanguard say they meet privately with company managers many hundreds of times a year. In analyzing hundreds of thousands of shareholder votes, Fichtner notes the index fund giants seldom vote against management in contested elections, such as DuPont Co.'s 2015 board meeting, when the two firms supported incumbent CEO Ellen Kullman's board choices against hedge funds and independent fund managers dismayed by weak profits.
-- At Bernstein Research in New York, the fund management analysis team headed by Inigo Fraser-Jenkins -- who admittedly works for one of the "active" stock-picking firms threatened by indexing -- in a 44-page paper last month called indexing potentially worse than "Marxist central planning," noting the importance of traditional stock-pickers in evaluating new companies that haven't made it onto anyone's index -- even though there are now more indexes than U.S. stocks.
- Hedge funds also have academic defenders. In a Journal of Financial Economics paper in February, Wharton scholars Todd A. Gormley and Dnald B. Keim and Boston College's Ian R. Appel found that indexed mutual funds help ensure "more independent directors," less resistance to high-priced takeovers, and "improvements in funds' longer-term performance." See also a Harvard Law School summary.
-- Individual investors are also free to ask "governance' specialists BlackRock and the other index fund groups have hired to pressure companies to reform, notes Matthew Tayler, partner at Permit Capital Advisors in West Conshohocken. Thanks to index funds, "they are able to more proactively engage with managements to address governance issues before they cause problems."