Index Funds – Passive or Parasitic?

Index funds have been rapidly increasing in popularity in recent years. It is difficult to argue with their results which tend towards an average of the active funds but favourably skewed by the lower charges applicable. This is all well and good but what happens if they come to dominate the investment landscape. In essence they are the very last thing a market driven capitalist economy needs as they are essentially backward looking and react neither to investment opportunities nor market news until these feed through into the market by active investor actions. In that sense they thrive by living off the actions of active investors without incurring any of the charges involved. It also implies there must be a limit to the dominance of passive funds as the more they dominate the more opportunities will tend to become available to the active investor. This would seem to be an interesting topic for academic study (though probably already done!). To take a Top 40 type fund as an example. Already it is apparent that these funds pick up new entrants after they have been doing well for a while and  lose them after a poor performing spell, which does not represent perfect timing. In a passive dominance scenario the active investor would drive up the price of attractive investments until they enter the index. At that point the Top 40 funds would have to purchase the share to fulfill their mandates, further driving the share up. At that point the active investor might sell on the basis either that the company has possibly already exploited most of the potential or otherwise that the price has been artificially driven up and will probably consolidate for a while. The active investor will be well placed in these circumstances.

A recent Economist article considers passive funds in much more depth. Its starting point is the inherent contradiction in capitalism between the theoretical ‘perfect’ market in which all possible information is known and acted upon and the active investor who is trying to go one better. They continue by saying that since 2008 in the US about $600 million of active funds have been sold off and $1 trillion flowed into passive funds. This means that the large asset managers between them are effectively the largest shareholder in most (weighted by size) listed US companies. This has been likened to Marxism in that investors are no longer allocating capital though as I suggested above there will always be active investors providing direction. A few other points of possible concern arising from a predominance of passive investors:

  • Investors are locked in, thereby allowing management free rein. [Does the race to lowest costs preclude passive fund managers from being active within the companies in which they are obliged to invest?]
  • By being large investors in a whole raft of companies do funds actively discourage competition which would drag down profitability of a set of companies and even if they don’t would the individual company managers perceive such price cutting etc as not in the interests of their shareholders. An analysis has suggested that company bosses are well rewarded for such ‘playing along’ which might not necessarily be in the best interest of the consumer and it is even said that CEOs perceive only a weak link between their performance and their remuneration, again restricting aggressive competition. The US Department of Justice is concerned about a concentration of power which is way above their comfort zone. [A later blog will revisit executive pay.]
  • On the other hand limiting the ownership stakes of the large passive asset managers would reduce the options available to retail investors.

The Economist’s suggestion is for antitrust rules to be enforced more diligently. It is nevertheless a tricky subject and it will be interesting to see how it plays out. All the argument at the moment seems to be in favour of passive funds but without recognising the inherent dangers, or at least the issues.

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