As index funds become more popular, corporate boards are increasingly finding themselves facing a less diverse shareholder base. To some, such a sea change from more concentration of shares held by big institutional investors — i.e., the "smart money" — is considered as a 'democratization' of how companies vote on different issues impacting investors. 

Proponents of active management credit a rise in the popularity of indexing as driving such changing shareholder dynamics. In their view, growing numbers of passive investors representing main street America — the "dumb money" — actually threatens to erode corporate "stewardship." A rather vocal group of "star" money managers have argued that a greater focus on broad asset classes over individual stock picking fosters an environment in which they're less incentivized to try to outguess markets.

As a result, a rising chorus of active managers are claiming that indexing is eroding their ability to take advantage of changing market conditions to take action. In effect, the claim is that active managers have some sort of crystal ball to look into the future and pick winning stocks over the long haul. The reality is that such prognostication tools are rather cloudy. According to the long-running SPIVA (Standard and Poor's Indices Versus Active) Scorecard, active equity fund managers have overwhelmingly failed to beat their respective S&P benchmarks — whether they've been focused on domestic or foreign markets. (See charts below.)

Active management contends that a growing concentration of assets in passively managed funds could lead to negative outcomes for investors. As two scholars noted in an often-cited 2019 research piece published in the Columbia Law Review:

"Index funds own an increasingly large proportion of American public companies. The stewardship decisions of index fund managers — how they monitor, vote, and engage with their portfolio companies — can be expected to have a profound impact on the governance and performance of public companies and the economy." ¹

In laying out a case that index funds are harmful to efforts to positively shape corporate governance, Harvard's Lucian Bebchuk and Scott Hirst of Boston University argue that "index fund managers have strong incentives to (i) underinvest in stewardship and (ii) defer excessively to the preferences and positions of corporate managers."

As pointed out by financial author Frank Partnoy in an in-depth review of such criticism in The Atlantic magazine ("Are Index Funds Evil?"), potential dangers of shareholder diversification have been floated by active managers since the early 1980s — "not long after index funds themselves did (come into existence)." ² 

An Objective Evaluation

Common ownership and shareholder diversification aren't just issues associated with index funds. Actively managed mutual funds that hold more than one individual stock in any particular industry are subject to the same criticism. If some critics want to make the case that common ownership and shareholder diversification are creating problems for the overall economy, it seems difficult in a practical sense to just disparage index funds.

The analysis piece by Partnoy, which is still considered in many academic circles as pioneering work into this topic, cites similar findings by researchers Jose Azar, Martin Schmalz and Isabel Tecu (2017). In looking specifically at the airlines industry, he summarized the body of their findings: 

"Overall, it said, the high concentration of share ownership had caused serious harm to consumers in the airline industry: Ticket prices were as much as 12 percent higher than they otherwise would have been, because of common ownership of shares. The authors measured how competitive individual routes were, based not only on how often each airline flew a given route—which regulators already examine—but also on the degree to which each airline's shares were held by common investors. They found that adding common ownership increased the level of concentration on the average route to more than 10 times higher than the levels that regulators presume to be the problem."

This explanation could be suspect to spurious correlation, which leads us to another point. While common ownership has increased over time, so has market concentration through mergers, acquisitions and bankruptcies. For example, major airlines have merged — from United and Continental as well as Delta and Northwest to American and U.S. Airways.

Is this because shareholders of these companies' vis-a-vis index funds are urging this type of behavior? Or is this just the natural course of capitalism, in general? 

Index Funds are an Easy Scapegoat

In our view, it seems too easy to blame common ownership. Index funds have been called a lot of things over the past few decades — including everything from "Un-American" to "parasitic." More recently, we see active managers trying to label passive investing as "evil."

To us, the active crowd pegging index fund managers for the low-growth outcomes associated with anti-competitive corporate decisions is too simple. Even so, indexing has become a target of scapegoats. As author Partnoy puts it: "An array of new research blames common ownership for various ills, including high bank fees and stratospheric CEO pay … One journal article argues that large index funds are violating antitrust law."

Let's think about this for a second. Does it seem reasonable that the likes of Vanguard, Blackrock or Dimensional Fund Advisors are using their ownership muscle to influence corporate board decisions to break U.S. anti-trust laws? 

Most index investors see the merits of market competition as it can lead to innovation, lower costs and more efficiency in terms of how resources are allocated and utilized. Competition, specifically in the capital markets, is the reason why many investors decided to start index investing in the first place. Why bite the hand that feeds you?

Many of the fund companies that do have a large amount of assets that are indexed have pushed back on these claims. Indeed, Dimensional Fund Advisors has established a dedicated corporate governance group. This group has built a record of activity in such an area. In fact, that internal effort has led to several policy reviews, one of which as shared with us states: "We seek to impact governance in several ways, including through proxy voting and listening to companies held in the portfolios we manage. We also seek to improve internal processes through research on governance matters and participation in industry surveys and events." 

Like most things, the issue of corporate governance can be messy and fodder for a good deal of debate. On the one hand, we need private market incentives such as patents and copyrights in order to motivate individuals or businesses to develop products and innovate. There must be some sort of private reward for putting in their effort and risking their capital.

The flipside of this argument is the potential for a particular company to dominate the market and dictate prices for consumers. This is where competition plays a vital role — such a tug-of-war between incentives and competition is what really matters and where civil debate should be engaged. At IFA, our wealth advisors like to warn that pointing fingers at popular passive managers and playing ‘the blame game' with index funds is ultimately taking a complex issue and oversimplifying it.

Footnotes:

1.) Lucian A. Bebchuk and Scott Hirst, "Index Funds and the Future of Corporate Governance: Theory, Evidence and Policy," Columbia Law Review, December 2019. 

2.) Frank Partnoy, "Are Index Funds Evil?" The Atlantic magazine, September 2017. 

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