Index Investing’s Risk Or Reward

May 09, 2019

In the ETF world, we are often fans of passive investing. More than 90% of all assets tied to ETFs sit in index-based portfolios, many of them extremely cheap to own.

Studies on active manager performance consistently point out that active rarely beats passive, which is why passive investing keeps on growing. Morningstar data show passive strategies today represent 49% of U.S. equity fund market share, almost at parity with active in what has been a sustained upward trend, and one unlikely to be deterred.

Index Funds Eating The World?

At the Morningstar Investment conference this week, one panel tackled the burning question some are asking: Are index funds eating the world?

In what turned out to be a heated debate between practitioners and academics, the overarching conclusion of the discussion was a resounding “agree to disagree.”

Rakhi Kumar, head of environmental, social, governance (ESG) investments for State Street Global Advisors, and regulatory advisor and Morningstar contributor Jasmin Sethi offered a case of index funds being often maligned for their growth despite all the benefits they bring investors; namely, low and lowering costs.

“I struggle with the idea of a negative connotation with the growth of index funds given all the benefits they have brought to investors,” Kumar said. “Growth has been centered on low cost funds and on the underperformance of active.”

Risk Of Ownership Concentration

Eric Posner, law professor at the University of Chicago, where he’s a financial law expert, argued the theoretical risk of ownership concentration. Posner showed that the six biggest banks in the U.S. today have the same three firms as among their top five shareholders: institutional investors Vanguard, BlackRock and State Street. The same can be said of supermarket chains and other industries.

As he put it, if you take two companies in the S&P 500, how often is the case that the same institutional investor is the biggest shareholder of these two firms? It used to be that this happened 20% of the time back in the mid-1990s. Today it’s 80%. Passive investing has led to a concentration problem, he says.

‘Consequence Of Growth’

“I’m a huge fan of index funds, but the problem is, over time, there’s a growing concern over the possible consequences of their growth,” Posner explained. “The problem with common ownership in index funds is that you have institutional firms—BlackRock, Vanguard, State Street—become the biggest owners of companies like Ford and GM. It hurts these companies’ incentive to compete with each other, leads to higher prices and slower economic growth. That’s the theory.”

Disagreeing on that assessment, Kumar argued that index investors aren’t engaging with companies on price or direct competition in a segment; they are engaging on long-term governance issues. So, concentration as detrimental to competition among companies is “unlikely to be a practical concern, more of a theoretical concern,” she noted.

Everyone agreed monopolies and oligopolies aren’t a good thing for the market or investors. But as far as what role passive investing has in tearing the fabric of markets as we know it, the debate still rages on.

Contact Cinthia Murphy at [email protected]

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