Ensuring your invested capital outperforms the market can be a task akin to finding a needle in a haystack. To find that elusive outperformance, many retail investors place their money in actively managed trusts or funds and pay fees to professional investors (needle-finders). However, increasingly, investors are opting for another route: picking up the entire haystack – the market index as a whole – and running with it.
This approach, known as passive investing, was pioneered in the US by Jack Bogle and his company Vanguard in the 1970s. The strategy has increased in popularity of late with the growth in the range of exchange traded funds (ETFs) and the seemingly never-ending momentum in the global bull market. The idea is that by buying all the assets in one index (or a representative sample of them), an investor can gain exposure to the whole market, or a certain segment of the market. However, concern has been raised that growth in the popularity of passive funds and ETFs could be damaging the UK economy.
The fear is that the boards of companies largely owned by passive investor shareholders may effectively get a ‘free pass’ from them. Since the 1970s, agency theory – the idea that companies should attempt to maximise shareholder returns and that shareholders should hold management to doing so – has been widely accepted. The worry is that with the growth of passive investing, there are too few active investors to put meaningful pressure on boards.
Passive investors, it is suggested, pay no attention to the management and corporate governance of a company or the returns generated, but are interested only in a company’s market capitalisation. At the same time, they are deemed less likely to be actively involved in shareholder meetings and holding companies to account than active investors.
A related concern is that because of the diversification of passive portfolios, managements of companies have less incentive to innovate and compete, particularly on price. A well-known 2014 study by José Azar at the University of Navarra IESE Business School looked at airline companies in the US with overlapping ownerships of passive institutional investors, primarily investing through index funds. The study suggested that ‘common ownership’ resulted in ticket prices ‘approximately 3-5 per cent higher on the average US airline route than would be the case under separate ownership.’
The theory is that passive ownership can lead to tacit agreement between managers and institutional owners not to compete too heavily on price – or at least to agreement that it would not be in the interests of passive investors to have the companies they own compete. It’s worth pointing out, however, that the paper has been hotly disputed both empirically and theoretically.
Most notably, passive funds have been accused of threatening the very underpinnings of capitalism, in a 2016 paper by equity sell-side broker Bernstein Research entitled ‘The Silent Road to Serfdom’. The paper claims that ‘passive investing is worse than Marxism’. With capitalism, it states, capital is allocated via the stock market by active agents – active managers primarily – seeking companies that make the best use of resources that add value, or profit. However, passive investing, which simply follows an index, is deemed even more damaging than the planned economies of communist states. At least in centrally planned economies, the paper argues, the state acts as an agent – however cumbersome and bureaucratic – deciding where to allocate capital. Passive investing, in contrast, just distributes capital across an index. There is no agent.
Jason Hollands, managing director at Tilney Bestinvest, says: ‘The whole point of a stock market is that it is a place where businesses that need capital can come and raise it from investors, and once listed, the value of the business will be determined by individual decisions and views taken by a myriad of investors. This process of price discovery and constant evaluation by investors should in theory lead to the efficient allocation of capital towards businesses with the greatest potential, which in turn should be good for the economy.’
Hollands adds that, by contrast, passive investing is ‘predicated on acknowledging that markets are, over the long run, efficient in allocating capital and that [passive investors] just follow the decisions made by others, who will correctly price businesses – essentially getting a free ride off active investors’.
‘What happens,’ he asks, ‘if we reach a tipping point where so much of the market is owned by passive investors that this starts to undermine fundamental price discovery, leading to the misallocation of capital to businesses?’
This could result in certain companies being ‘propped up by buyers just because they are large, irrespective of their fundamental qualities, while younger and smaller businesses are starved of capital because they are barely or not represented in major indices’.
Hollands adds: ‘A world in which most or all of the market ends up being owned by passive funds would be dystopian.’ It would be one ‘where valuation bubbles would be reinforced, weak management at larger companies given a free pass, and access to capital via the public market by new and innovative companies highly constrained.’
However, Eric Balchunas, an analyst at Bloomberg Intelligence who focuses on ETFs, is sceptical about such arguments. At least for now, he doesn’t see ETFs harming or undermining the functioning of capitalism. ‘There’s a blurred line between capitalism and the stock market,’ he says. ‘When you consider private and family-owned firms, capitalism is way bigger than stocks.’
He thinks ‘active managers overstate their role in capitalism’. ‘Steve Jobs didn’t invent the iphone because of T Rowe Price managers,’ he says. Likewise, responding to the argument concerning the supposed problems passive investing presents for corporate governance, Vanguard’s Jack Bogle is dismissive of the corporate governance role played by active investors. ‘Corporate governance,’ he said in a recent interview with Morningstar, ‘should be based on long-term factors affecting a firm, not the actions of a bunch of traders who want [the firm] to report higher earnings and who try to get on the board for a minute to realign the entire company. It just doesn’t happen.’
Oliver Smith, a portfolio manager at IG, is also sceptical about the corporate governance claim. He says: ‘If you look at the records of many asset managers, they haven’t taken responsibility in the past. One thing ETF providers are doing is taking corporate governance seriously.’
He suggests that investors should be wary of criticising passive investors for undermining capitalism and that Bernstein Research's contention that passive investing is ‘worse than Marxism,’ is hypothetical. ‘You have to get to a really extreme place [for such criticisms to start making sense],’ Smith says. ‘In the US passive investing accounts for just 15 per cent of ownership.’ He adds that there could ‘theoretically be a problem if passive vehicles increase’. But for now, fears are overblown.
Passives being scapegoated
There are two reasons why it can seem that passive investing is overwhelming the market, according to Balchunas. Some 30 years ago, he says, markets were 99 per cent active. So the rapid erosion of active management’s dominance makes ETFs’ rise seem more pronounced than it is. It’s also the case that people feel ETFs have taken over because daily flows are so large. Such factors give the impression that passive investing is taking over, he says, but ‘active is still king’.
Much of the criticism of ETFs comes from ‘frustrated active managers’ who scapegoat passive investment, Balchunas says. Over recent decades, active managers could have lowered fees much more than they did, he suggests. Their criticism, is ‘more of a sales pitch’ than a real concern. He notes that Bernstein Research, which published the paper alleging that passive investing is worse than Marxism, has recently launched its own ETF, though these include active elements.
Balchunas says that instead of spreading scare stories, active managers should find ways for ETFs to work alongside active funds. ‘A lot of active managers probably have ETFs in their personal accounts,’ he adds. ‘They are too good a deal.’ He points out that ETFs offer investment opportunities at almost zero cost. Oliver Smith makes a similar point. He says that ETFs provide a ‘great transfer of wealth to consumers’ and that ‘that is to be applauded’.
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