Rising power of the asset management kings

The exchange-traded fund (ETF) started life as an oddity in a corner of global markets. It grew in importance as the low-cost leveller for retail investors but largely remained a sideshow in the early days. During the past decade however, it has mutated and now dominates stock markets worldwide. The problem is just how safe are they and what are they doing to share prices and retail investor behaviour?

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Humble beginnings

The ETF was developed to prevent something like the 1987 Black Monday stock market crash happening again. Still to this day, 19 October 1987 is the largest single-day drop for the Dow Jones at 22.6%. The Securities and Exchange Commission (SEC) investigation found that a lack of liquidity in single stocks, when exacerbated by modern computerised trading techniques, had caused a panic.

The solution came six years later when State Street Global Advisors launched the SPDR S&P 500 ETF Trust (SPY) in 1993. The theory was that creating a portion of the market that held a basket of shares could act as a crucial circuit breaker by offering prices on all shares even during extreme market conditions. That’s opposed to market participants driven by fear selling at any price.

Legendary investor and founder of Vanguard, the late Jack Bogle, was one of the first to see the potential and aggressively repositioned his fund management company behind the ETF in 2001. Around the same time, Barclays Global Investors launched the iShares brand in 2000 to focus on retail growth. After heavy losses in 2008, Barclays sold its iShares ETF business to BlackRock Inc (NYSE:BLK).

Fast forward to today and the top five global asset managers have exploded in size as retail investors flooded into stock markets and ETFs looking for a home for their Covid-19 furlough payments. BlackRock currently manages $13.9 trillion (£10.3 trillion), Vanguard Group, $11.6 trillion, Fidelity Investments $7.1 trillion, State Street Global Advisors $5.7 trillion and J.P. Morgan Asset Management $4.1 trillion.

The amount of money held in ETFs has ballooned from around $4 trillion in 2020, to over $16 trillion today. Every large company on the stock market has a similar register of top holders. Using Apple Inc (NASDAQ:AAPL), one of the biggest companies in the world, as an example, its top five holders are BlackRock at 8%, Vanguard Capital at 6.6%, State Street Corp (NYSE:STT) at 4.2%, Geode at 2.5%, and Vanguard Portfolio at 2.3%.

Rising power of the asset management kings

As asset managers have increased their holdings in the largest companies in the world, which pay billions in taxes and employ millions of people, so their influence has risen. No more so than the founder and BlackRock supremo Larry Fink. When Donald Trump visited China for a two-day summit with Xi Jinping in May this year, he was accompanied by Fink, Tim Cook from Apple, Elon Musk from Space Exploration Technologies Corp Class A (NASDAQ:SPCX) and Tesla Inc (NASDAQ:TSLA), and Jensen Huang from NVIDIA Corp (NASDAQ:NVDA) among others.

Fink has also segued from finance into geopolitics through the acquisition of Global Infrastructure Partners in 2024. This deal brought around $170 billion in critical infrastructure across 100 countries including Gatwick and City Airports in the UK. Global Infrastructure Partners paid $22.8 billion to buy two ports at either end of the Panama Canal from Hong Kong-based CK Hutchinson in March last year, which allowed Trump to claim a much-needed win on the global stage.

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During the first Trump administration when a review into scaling back Wall Street regulation was undertaken, former managing director at BlackRock Craig Phillips was brought in as counsellor to then US Secretary of the Treasury Steve Mnuchin. There is also Mark Wiseman, a former BlackRock managing director, who is the Canadian ambassador to the US.

The asset managers are clear that as passive investors they exert no influence whatsoever on company decisions or policy. Vanguard was even forced to sign formal passivity agreements with the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) over its holdings in US banks.

The big asset managers may claim simple passivity, but there is no denying their sheer size. The “Big Three” of BlackRock, Vanguard and State Street now own around 25% of the voting rights at shareholder meetings across the entire S&P 500. The problem is that breaking the link between shareholder ownership and stewardship could unleash unintended consequences for markets. 

Breakdown of accountability

Retail investors who buy into ETFs receive the benefits of share ownership with none of the costs associated with holding management to account. Whereas the asset managers who create the ETF and own the underlying shares incur the cost of governance and hand on the benefits. Asset managers are richly rewarded for creating the ETFs, but it could create an environment where they are incentivised to spend less on the governance of each underlying company.

When retail investors buy individual shares, they can hold management to account by voting at annual general meetings. They don’t always do this, but crucially when stirred into action they can, and that ability can help keep management in check. If a huge block of the shareholder register is owned by an absentee landlord, it removes that ability and management have less accountability.

A study entitled “Is There a Dark Side to Exchange Traded Funds (ETFs)?” completed by Stanford Business School in 2015, found that ETFs can have a chilling effect on the function of the stock market. Far from being a universal good, the research showed that ETFs just buying and holding large chunks of the market can begin to change how the whole stock market behaves.

Previously, the market was dominated by fund managers and retail investors who were stock pickers. It paid to invest time to understand the latest earnings figures and company dynamics as it would allow you to earn greater returns from your investments. This has been blown away by the constant flow of retail cash into index funds and ETFs. The ETF asset managers simply buy and hold the shares based, among other things, on the weighting within the index. Maintaining stability is the key.

As a result, increasingly the greatest driver of market performance becomes the momentum of new cash itself, and it offers less return to do the research. Pricing can become divorced indefinitely from the underlying performance of the company as long as new cash is coming into the index. Management teams of the biggest companies will also come under less scrutiny from shareholders as their biggest investors just buy and hold regardless. The stock market itself begins to just align and move in one direction, rather than being a voting and weighing machine based on predicted earnings.

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There are other issues worth considering as well. ETFs can be traded at any point during market opening hours, and proponents sight this as a clear advantage. And while it is true that this gives them an advantage over mutual funds that are priced once per day at the closing value of all the investments in the fund, or net asset value, the liquidity and lower management cost structure of ETFs comes at a price.

Retail investors put a record $1.5 trillion into ETFs last year, and those flows are not linked to company earnings or other price-sensitive corporate news that would usually drive share price movements. Instead, it creates stock market momentum that can be driven when people receive their pay packets or a news report about how markets are at record highs.

As share prices rise, it attracts more retail investors to follow suit into index ETFs which in turn drives prices higher. It then becomes the momentum itself driving gains rather than fundamental performance of the underlying index. Investors also chase themes that have performed best, such as AI and technology sectors.

The feature of stock markets driven more by momentum and vibes has accelerated with the addition of leveraged ETFs. They allow investors to buy an ETF that can deliver up to three times the performance of an underlying share.

Why buy shares in Dell Technologies Inc Ordinary Shares - Class C (NYSE:DELL) computers that have risen 350% in the past 12 months when you can buy an ETF in the same company that will deliver 3x that, or 1,050%? The issue is that this leverage exposes investors to far higher risks and potential losses.

Investors should note that many leveraged products have the word “daily” in their title. That is there for a reason, as the article below explains. 

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The growth in size of borrowing to invest in the stock market has reached record highs. At the end of June, there was $1.5 trillion in margin debt that was bet on the stock market, more than double the $700 billion that existed at the end of 2023.

The use of derivatives exposed to the stock market has also reached a new record. More than four million S&P 500 index calls traded on Cboe Global Markets on one day at the start of this month, beating the previous daily peak for trading activity.

Hurtling into an unknown future

The sudden raft of mega-cap IPOs this year has merely accelerated the features of a more concentrated market less reliant on earnings information.

In anticipation, some index providers have been making changes to their own rules. For example, the Nasdaq 100 tweaked its index inclusion rules, allowing newly listed companies, such as SpaceX, to enter the Nasdaq-100 after only 15 trading days rather than waiting several months. As part of the changes, Nasdaq removed its previous 10% minimum public float requirement.

The rules have been changed because a company like SpaceX is potentially so large it must be included in the index, even though it initially offered 5% free float of shares. This has led to another workaround, with the market capitalisation adjusted in proportion to the free float of the shares when determining its size in the index.

The companies coming to market this year are far larger than anything seen before. Their size is being determined by funding rounds of the companies that founded them in the first place. In a further complication, the number of shares being offered at flotation is far below the normal threshold for a company being considered for admission into an index like the S&P 500. This is because such a small free float of shares could be open to manipulation and risk being unreflective of the true value than if a higher portion of the shares were traded on the open market.

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This has a number of important implications for investors. The SpaceX IPO initially didn’t have a very large impact on the index as only 5% of the $2 trillion market cap hits all the various index-linked ETFs. However, from 8 December the free float begins to rise closer to 50%, with Musk retaining the other 50% until his lockup expires in June 2027. As the free float of SpaceX shares increases tenfold, then its weighting across indices and related ETFs will begin to rise accordingly. This will happen through a managed process as major indices tend to rebalance on a quarterly basis. But investors must be comfortable with how much their exposure to the AI boom is changing. This will only be compounded by the expected IPOs of OpenAI and Anthropic.

As the indices are rebalanced and become more concentrated on AI and technology, they could lose their weighting in smaller midcap and real-world industrial names. This could create an opportunity where shares in smaller mid-cap names could become cheaper simply by losing their weightings within the index.

One feature of ETFs that replicate an index is that they incur higher costs when they have to track a higher number of more evenly sized companies. As stock markets become more concentrated in a few much larger companies driven by momentum, the cost of administration falls for the asset managers. 

The ETF monster

There is no denying that ETFs have been a fantastic new product for retail investors. They have opened access to all sorts of new asset classes and attracted millions who enjoy higher levels of returns from stock markets. Also, it is difficult to argue that growth of the ETF universe has been detrimental to capital markets, with record highs around the world. They have arguably done exactly what they were designed to do, decrease risk, decrease panic selling, act as a circuit breaker during sell-offs and attract new capital into the market.

But it could be argued that what we’re left with now is a Frankenstein market. Price discovery based on the fundamentals of the underlying company has diminished as cash pours into index funds. Record amounts of new money to the market since 2020 have focused on fewer and much larger companies, allowing ETF managers to make even more money from index trackers.

What started out as a simple investment tool to reflect the underlying index has now started to shape the index itself.

The stock market has drifted from the least-worst method of allocating capital to one that has a greater herd mentality detached from underlying returns. Everyone is happy when markets trade near record highs, but it’s worth thinking about whether this is a good thing and what the risks might be. 

John Ficenec is a freelance contributor and not a direct employee of interactive investor.