In his first column about the ETF industry, Tom Bailey discusses the role of passive investing in changing capitalism and asks whether investors have a duty to help reverse the trend.
This is the first Tom Bailey column, which will cover index investing, factors, markets and macroeconomics, aimed at anyone interested in exchange traded funds.
The rise of passive investing, in the form of ETFs and index funds, is changing capitalism.
As I pointed out recently, the argument is that if you are a business, having your shares owned by the same handful of index-fund giants as your market competitors incentivises against competition. If your shareholders also own shares in your competitors, engaging in a revenue-eating price war over market share is not welcome. Likewise, there is supposedly less incentive to spend money improving your product to gain market share. Good for the shareholder; bad for the consumer and the economy.
The theory is highly contentious and hotly disputed, with the main argument being that there appears to be no clear idea of how, or when, index-fund shareholders tell the managers of companies to behave in a less competitive way.
Another argument is that passive investing means worse corporate governance. An active manager, the theory says, is likely to be an engaged shareholder, studying the strategy and reports of the firms they own and better holding management to account. Active managers have the semi-credible threat of selling shares if management is seen as behaving badly or pursuing a bad business strategy.
Index funds, meanwhile, own the whole index by design. This makes them less likely to be engaged with their holdings. Likewise, as they are compelled to own every company in the index they track, they do not have the threat of selling to enforce behaviour.
Again, this is highly contentious. The theory probably relies on an idealised version of shareholder engagement from active managers. It also assumes that passive fund giants will not engage themselves in corporate governance. In reality, BlackRock and other ETF giants are clearly increasingly involved in corporate governance, particularly from an ESG (environmental, social and governance) perspective.
This, however, opens up a new question about how passive investing is changing capitalism, with the increased concentration of corporate decision-making in the hands of a few index-fund giants. As Vanguard founder Jack Bogle once noted: “A handful of giant institutional investors will one day hold voting control of virtually every large US corporation.”
Finally, the growth of passive is said to imperil price discovery and the efficiency of the market. As advocates of passive strategies often argue, the market is efficient because it is full of very clever professional investors with tremendous research capabilities. Their combined efforts mean that share prices are usually the best approximation of their fair value.
However, if increasing amounts of money are flowing towards passive strategies that simply buy stocks based on market-cap weighting, prices will become less efficient. So, the price of shares will no longer reflect fair value as well as they currently do or once did. If passive investment ever came to constitute almost all of the market, it would be impossible to know what anything should be priced at.
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The counterargument is that if prices become less efficient, active managers will start to be able to produce higher returns. This should trigger a flow of investor money back into active funds – at least until prices become efficient once again. After all, the principle reason investors have flocked to passive funds is because so many active funds have failed to consistently beat the market due to its efficiency.
Either way, these are all interesting and important questions about the changes that passive investment is bringing to the economy. But it shouldn’t play a role in investors’ decision to use ETFs rather than actively managed funds, as it sometimes seems to be argued.
The most blatant example of this I have seen was from an active fund manager at an event I attended. The manager cited Bogle speculating on a hypothetical world where most or all of the market is owned through passive vehicles. Such a thing would potentially have serious implications for price discovery, corporate governance and competition. But the implication from the fund manager was that this was a reason for investors to stick with actively managed funds (like his) and not go down the passive route.
There are plenty of arguments for why investors should stick with active managers - but the potential market structure and economic implications of passive funds is not one of them. Even if we were to accept the potential negative results of passive vehicles on the market’s efficiency and health of the overall economy, it is not the role of investors to invest on such basis.
That’s not to say that investors should ignore all this. On the contrary, they should play close attention to the theories about the market and economic impact of passive investing , just as they would any big economic trend, be it the rise of China or income inequality. But investors have no duty to invest to try and influence, direct or reverse these trends. By the same token, investors should not feel like they should avoid passive vehicles because of some weird sense of duty to keep markets efficient or firms competitive. From the individual investor’s perspective, individual returns are what matters – if passive investing looks like a better guarantee of that, that should be how they invest.
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What is beneficial at the individual level is often harmful in aggregate. The idea that when something is good for an individual it can also be harmful when everyone else does it is a familiar concept in economics, known as the fallacy of composition. The most famous economic example is John Maynard Keynes’ paradox of thrift. Saving is a good thing, on an individual level. However, everyone saving more at the same time is not good when looked at from the perspective of the overall economy. One person’s spending is another person’s income, so if we all spend less and save more, in aggregate we become poorer.
But we do not object to people for choosing to save more during a recession. We accept that on an individual level it is a rational choice. The government and other state bodies enact policies to try and incentivise different behaviour, such as lowering interest rates or subsidising meals out between Monday and Wednesday.
Likewise, there is no point berating passive investors for choosing to invest in a way that is often better for individual returns because in aggregate it potentially makes markets less efficient and hurts the economy. If passive investing is such a menace to the proper workings of capitalism, it is the role of the state to create new incentives or regulations. Fund managers telling passive investors that they are destroying capitalism just looks like naked self-promotion.
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