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Bogle Sounds a Warning on Index Funds

228 points by scdoshi 8y ago

neogodless 8y ago
Maybe I'm misunderstanding something, because I find it odd to hear this from Bogle himself. Vanguard doesn't own or control the equities in their index funds. You do. Vanguard is structured so that you can own your piece of the index fund pie. And while there are large holders of index funds such as Vanguard's Total Stock Market fund, I don't think there are any majority holders. For 51% of equities to be channeled through Vanguard but owned by stockholders does not seem to be a risk. If I'm wrong, can you explain what I'm wrong about?
- jonbarker 8y ago
  The risk is that Vanguard, State Street, and Blackrock, employ small 'governance teams' whose job is to vote on your behalf. Since they don't have an explicit fiduciary duty to the shareholders of the index funds, but do have an implicit one, it can be argued that you don't actually have a vote in how the component companies are run. More here: https://outline.com/njXPEu https://outline.com/njXPEu
  - jschwartzi 8y ago
    Vanguard explicitly asks you to vote your shares. I've gotten letters in the past asking me to cast a vote.
    - travisp 8y ago
      Vote on mutual fund governance questions. Not on each of the thousands of companies that the fund is invested in.
    - jonknee 8y ago
      You do not get 3,641 letters asking you to vote in each of the companies that make up VTI. If you own shares of a company directly you will get a letter and you may get a letter about governance of the fund you own, but not for the individual names in it (you own a piece of something that owns the actual shares).
- clairity 8y ago
  the issue arises because typically the fund acts as your proxy when it comes to voting rights (most index investors are looking for a reliable and easy return, not a voice in corporate governance).
- deleted 8y ago
  [deleted]
- chmaynard 8y ago
  > Vanguard doesn't own or control the equities in their index funds. You do. Is this statement correct? Your argument hinges on it, so it's important to get a definitive answer.
  - privateSFacct 8y ago
    No it is not. It is 100% false with respect to voting rights. The most visible sign of Vanguard’s engaged ownership is our funds’ proxy voting at shareholder meetings. We have an experienced group of analysts on our Investment Stewardship team that evaluates proposals and casts our funds’ votes in accordance with our voting guidelines. Fund holders do not vote on corporate issues of stocks held by vanguard. And of course, the owner of stocks held by a mutual fund are the mutual fund. Is that not clear to most people?
gregorymichael 8y ago
A bit click-baity, but the warning here from the father-of-index-funds is not that they've become a bad investment, but that their popularity is leading toward a handful of financial institutions holding controlling interests in most of the largest companies. Pretty interesting unitended consequence.
- fitchjo 8y ago
  He is mentioned here pretty regularly, so many may already be aware, but Matt Levine discusses this and its variants a lot in his newsletter, most of the time under the heading "Should index funds be illegal?"
- sseveran 8y ago
  I have a hard time seeing it as unintended. If you are not promising any differentiation between yourself and the index than the only thing to really compete on is cost. There are economies of scale in finance, specifically if you need to optimize solely for AUM.
  - davio 8y ago
    There's definitely a race to the bottom going on with the free Fidelity funds and Vanguard reducing the dollar minimum by 70% for a lot of admiral shares.
    - barrow-rider 8y ago
      Vanguard is doing "Auto" Admiral too -- if you meet the 3k minimums for Admiral funds they're auto converting you anyway. Race to the bottom or not, competition works.
    - refurb 8y ago
      Yet another great example of "race to the bottom" benefiting consumers. Not sure why it's used in a negative way all the time.
      - 8y ago
brianliou91 8y ago
This is fascinating. Selfishly though this seems to signal for investors of index funds (such as myself) that they will only continue to be good investments unless major government regulation occurs. Does anyone know of any investment risk to index funds if everyone is now doing it?
- ams6110 8y ago
  I don't consider myself very savvy in investing, but I guess if "half of all stocks" are owned by index funds that's a concentration of ownership that might be considered unnatural at best. I didn't read past the paywall but one good thing if more and more people own index funds then they are participating in the success of those corporations represented in that index. Might tend to tone down some of the shrill agitation that everything "corporations" do is evil and greedy.
- pge 8y ago
  one risk is that if too many people are invested in index funds (passive, not buying or selling based on new information), then the price of those stocks is determined by a small group of active investors
  - bluGill 8y ago
    So long as the pool is large enough that doesn't matter. Index funds just need the price to be close to reasonable to work out. When the price is not reasonable index funds do well. In general active investors work to push the price to reasonable levels. Of course there is such a thing as price manipulation which active investors can try - if there are only a few and they work together this can work out. However the investors have incentive to cheat when working together as the cheater wins against his peers, thus this currently is confined to "penny stocks" (for example the company behind the stock doesn't exist anymore but they didn't properly delist their stock so technically it can be traded - you can buy such stocks for say a penny each and then hype them to suckers as the next big thing and sell for 10 cents each and make a killing - since the company doesn't exist no one else pays attention and the scam works.)
- 8y ago
cs702 8y ago
If the stock market becomes dominated by copycats copying each other, can it price equity risk accurately?
- notacoward 8y ago
  > can it price equity risk accurately? When was the last time they did that anyway? Or tried? For a while, Wall Street has been more interested in predictability or volatility than in actual risk. They flat-out don't care whether an investment will tank, so long as they can predict (or sometimes even control) the timing. Or use some minute technological advantage to reap the rewards before someone else does. The very nature of hedge funds is to be good at measuring potential arbitrage rewards, not actual risk. Copycat behavior only exacerbates a problem that already existed.
- et2o 8y ago
  Sure, as long as there are some individuals or firms who are not invested into index funds. Theoretically they might even prefer this situation, since if they can accurately price equity risk they will make more money if everyone else is wrong.
- nabla9 8y ago
  As long as there are at least some active investors left they can, because they follow price changes set by active investors passively. If index funds start to create systematic valuation errors, active strategies start to perform better and they start to outperform index funds. This is not the case, because index funds beat active fund management constantly over longer periods. (The article raises concerns of corporate governance and accumulation of power that is different issue). Matt Levine https://www.bloomberg.com/opinion/articles/2016-08-24/are-index-funds-communist https://www.bloomberg.com/opinion/articles/2016-08-24/are-in... >there is an alternative view that the rise of passive investing will improve capital allocation, because bad active investors will be driven out but good ones will remain. The passive investors can't influence relative prices, since they just buy the market portfolio, meaning that the fewer but better active investors will continue to make the capital allocation decisions. On this view, lower returns to active management are a sign that prices are more efficient and capital allocation is getting better
decimalst-s 8y ago
Is there anything legally preventing these funds from having some kind of system where you have fractional voting rights proportional to your number of shares in the mutual fund vs. the weight of the company in the index it represent? e.g. You have 100 shares of a mutual fund that has 1% of its holdings in some company- thus you have 1 vote for that company's shareholder ballot, or whatever the fractional representation based on market cap would come out to. I'm not sure if a single holder of funds can cast "partial votes" in each direction though. Either way, it seems like a problem that could be fixed through technology.
- et2o 8y ago
  They could even just hold their own internal vote immediately before the actual vote and net out the results. Then vote this result in the actual vote. I don't think there is a rule that if you vote, you must vote with every share. Also gets rid of any issues of fractional voting; they can track fractional votes in the internal vote, and then just round the result in the actual vote. The biggest problem is that generally index funds try to take a pretty passive approach to management decisions (although they do vote in some circumstances). If the index funds allow their investors to vote on everything, to some extent they stop being an index fund that passively tracks the market.
  - justin66 8y ago
    > If the index funds allow their investors to vote on everything, to some extent they stop being an index fund that passively tracks the market. That doesn't really follow. Tracking the index and voting are two separate concerns. That's part of the point of Bogle's objections (I think - I can't read the article, I can only read about it), that they're involved in management already, even though that's not part of their mission. Simply voting based on a proxy vote of the fund's shareholders is arguably more "passive" for the fund management than what they're doing now, if you're concerned about passiveness.
    - et2o 8y ago
      I have to disagree. > Tracking the index and voting are two separate concerns I do not believe this is really true. The entire point of exercising shareholder rights by voting is to improve the performance of the company. A shareholder's decisions might be right (improved stock value) or wrong (reduced stock value), but you can't argue that it's passive involvement in the company. Changes in a company's stock price will necessarily cause changes in the index that the index fund tracks. Now, let's consider the point of an index fund with a passive investment strategy: the goal is to remove the need to make decisions in how a company operates and leave that to the better-informed investors and marketplace as a whole. Index funds in the ideal world simply want to ride along with what decisions the marketplace is making in the companies that the index tracks. This is an important tension that really cannot be resolved if index funds are to be considered passive and also vote. In practice, the votes made my index funds tend to be (thus far) ones that are on less controversial issues like best practices for management, etc. You don't see Vanguard pushing for mergers or spinoffs like Carl Icahn would try to do. However, in principle all shareholder votes exist on some continuum of activist investing.
ajmurmann 8y ago
A while ago some article had a great example of what can happen if the majority of shares of most companies in the same industry are held by the same investors: It punishes competition within the same industry. The example was about the airline industry where investors don't want airlines to go head to head on pricing. While some companies might benefit from this, it would lead to lower margins and thus profits for the industry as a whole. So this in essence might form a cartel.
zAy0LfpBZLC8mAC 8y ago
(Index) funds solve a problem that we shouldn't really have anymore. The problem is that (semi) manually trading securities is inherently expensive. Funds solve that problem by massively reducing the number of transactions that are required: 1000 people investing in a fund investing in 1000 companies needs 2000 transactions instead of the 1000000 transactions needed when 1000 people invest in 1000 companies directly. But there really is no fundamental reason anymore why you shouldn't be able to just buy small numbers of shares from a thousand companies via electronic systems. A million transactions is not really a problem for modern IT, nor is managing 1000 positions in your account. Yes, there are some more practical problems (the valuation of individual stocks being too high for small investors to buy even a single one, preventing front running on index changes, tax refunds, ...) - but I would think all of those should be possible to solve in a way that is both economically feasible and has the individual investor holding the actual stock to prevent those accumulations of power. And you still could have the possibility to delegate your voting rights to some organization you trust--but that could be decoupled from the investment "product" or account itself, plus you wouldn't be required to delegate the power for all your investments. Or we could just make laws that mandate that funds must delegate voting rights to their investors, i.e., make it as if they were holding the stocks directly in that regard?
- dumb_troll 8y ago
  What about the problem that retail investors necessarily don't have good insights about individual companies (or stock pickers) but still want to benefit from economic growth?
  - zAy0LfpBZLC8mAC 8y ago
    Yeah, what about that? They get the same overall investment strategy as an index fund, just without the concentration of power?!
- mcguire 8y ago
  Tracking the index on your own would be more than a full time job. You could do it automatically, but that just reinvents the fund The S&P500 had 500 stocks. Do you want to vote ~1.5 times a day?
brootstrap 8y ago
Interesting. I've heard these warning signals before about index funds. Lets just hope index funds stay healthy for another say 60 years so i can fully utilize all the $$ I am dumping into the market now in my 20s. Please??
- djohnston 8y ago
  i thought an index fund's health depends on the health of the companies inside it. even if people decided they wanted to replace their index funds with direct stock purchases they managed themselves, the underlying value of the fund wouldn't change right?
turc1656 8y ago
I work in this industry. I'm on the indexing side of it, not the ETF/fund side. We obviously have relationships with all the major fund providers, especially the three big names mentioned in the article. And I happen to work for the big dog - S&P. "Why? Partly because of two high barriers to entry: the huge scale enjoyed by the big indexers would be difficult to replicate by new entrants; and index fund prices (their expense ratios, or fees) have been driven to commodity-like levels, even to zero." I can attest that is absolutely 100% true. This business structure is perfect when economies of scale come into play. And S&P is a master of this. It's extremely difficult for others to compete with us because, like everything else, there is a range of services/quality. S&P is at the top end - the Mercedes of index providers. People pay more, but they get the best service/products. The margins are extremely high for any business. But for an service that is considered to have been "commoditized" (and it has to a large extent), our margins are insane. All our competitors want to attack those margins but they have trouble because they aren't able to provide the quality, variety, or depth of service that we do. Which leaves them only able to charge much less and be on the lower end of pricing. Time and time again I've seen some clients leave to go with someone cheaper and become displeased and end up coming back. That's because they simply don't have the internal systems, data contracts, or expertise from having been doing this for as long as we have. Another thing is that the business model in general is damn near unbeatable. The 500 and DJIA combined require very little work overall as they are just two out of thousands of products we have. But they account for hundreds of millions of dollars in revenue. That's sort of like having a hit movie or book. But the difference with this business model as opposed to most other areas of capitalism is that the revenue is recurring. No where else have I seen unpatented, non-copyrighted intellectual property retain its value like this. Usually there is a surge at the start and then it tapers off fast after release/purchase. That creates a cash cow which they use to build stronger infrastructure and stay at the top. That being said, let me address the main concern of the article - the issue of ownership for the index funds (not the index providers). I might very well be missing something here, but the answer seems obvious to me. They should just update the law so that the shares owned by the fund providers aren't considered theirs but rather the end holders of the ETFs/funds that they are packaged into. In fact this is so obvious to me I don't understand how it's not already the law since that's the case for a lot of other things like this. If you have a Charles Schwab account and issue an order for a buy, they buy it for you by placing the order under their trading ID on the market. You are later updated to be a holder of record during the trade settlement process. Schwab is a service/pass-through agent. It's very similar for the fund providers. They just buy the shares to package/securitize in advance and then sell to someone. This is the creation/redemption aspect of ETF management. When the creation/redemption process goes on or ETF shares change hands, a process similar to becoming a holder of record through trade settlement should occur. Yes, that would result in you technically being listed as owner of a fractional amount of shares, but that's a hell of a lot better (and easier to deal with) than saying that the fund provider owns all the shares and you just trust them to vote properly for you.
btown 8y ago
https://outline.com/DGK9Td https://outline.com/DGK9Td
kjw 8y ago
Related to this, supervoting shares are popular with tech startups that are going public, but the street generally frowns upon these structures from a corporate governance perspective. Founders pitch supervoting control as a way to make sure the company can realize its long term potential by protecting themselves from activist investors with a short term view. So far, ownership of new IPOs hasn't been affected much due to their small market caps and subsequent miniscule weighting in indices. It will be interesting to see if increasing concentrated ownership by index funds may eventually play a factor and perhaps increase acceptance of supervoting.
pdog 8y ago
Of the proposed solutions, some combination of the following three items would be a solid first step (incremental without being too drastic): * Full public disclosure by index funds of their voting policies and public documentation of each engagement with corporate managers. * Require index funds to retain an independent supervisory board with full responsibility for all decisions regarding corporate governance. * Make it clear that directors of index funds and other large money managers have a fiduciary duty to vote solely in the interest of the funds’ shareholders.
- xkjkls 8y ago
  > Make it clear that directors of index funds and other large money managers have a fiduciary duty to vote solely in the interest of the funds’ shareholders. That's easy to say, but deciding what the shareholders interest is can be incredibly difficult. On any difficult decision, like "should this merger be approved", index funds taking any position is the same as active management.
fipple 8y ago
The summary: if Coke and Pepsi are owned by different guys, Coke will take an action that makes them an additional $1 million, even if (especially if) it causes Pepsi to lose $1 billion. Most commonly, cut prices. If the two companies are owned by the same guy, they have the incentive not to compete with each other since their owner cares about the sum of their profits. This is why one wouldn’t be allowed to acquire the other. But the effect is the same when a single index fund owns a large chunk of both companies. The companies are encouraged to compete not too fiercely with each other.
- Glyptodon 8y ago
  Even without index funds the drive towards large portfolios and diversification would do the same thing. I'd go so far as to say that unified ownership of competing firms by large investors is just unhealthy in general. Not really sure what can be done about it though since many companies are rather multi-industry.
  - fipple 8y ago
    Well the idea of an index, whether done through a fund or not, is to buy some of each company. A value investing approach would be to find the better stock and invest in it, so Coke stockholders would rarely own Pepsi stock and vice versa.
    - Glyptodon 8y ago
      Still, even without index funds, the first thing most people are told is that diversification is key and that sector allocation matters more than the specific companies you hold. Plus people want to mitigate risk, so they buy a little of each thing that matches whatever profile, and soon a sector essentially has unified ownership interests rather than competitive (and antagonistic) ownership interests.
  - guelo 8y ago
    If all the companies in an industry are owned by the same entity couldn't they be considered one company and then monopoly regulations would apply?
empath75 8y ago
> "There is no America, there is no democracy, there is only IBM and ITT and AT&T and DuPont, Dow, Union Carbide, and Exxon … The world is a college of corporations inexorably determined by the immutable bylaws of business. The world is a business, Mr. Beale, it has been since man crawled out of the slime. And our children will live, Mr. Beale, to see that perfect world in which there’s no war or famine, oppression or brutality. One vast and ecumenical holding company for whom all men will work to serve the common good, in which all men will hold a share of stock, all necessities provided, all anxieties tranquilized, all boredom amused." Network -- 1976
apo 8y ago
He also warned in 2017: Bogle noted that trading would dry up if the stock market comprised only indexers and there were no active investors setting prices on individual issues. Everyone would just buy or sell the market. ... Shareholders of index funds could then suffer more than owners of actively managed funds, and they could take their losses harder due to the perceived security they feel precisely because they merely own the market and aren’t trying to beat it. That might make active investors feel a bit of schadenfreude for indexers who have been free-riding at their expense, but the feeling probably wouldn’t last. The greater price swings that could ensue in a heavily indexed, less-active market are likely to exacerbate losses for everyone. https://www.marketwatch.com/story/john-bogle-has-a-warning-for-index-fund-investors-2017-06-01 https://www.marketwatch.com/story/john-bogle-has-a-warning-f... It seems a good bet that this warning, like most pre-downturn warnings, will only become obvious during the next major downturn.
peter303 8y ago
He didnt mention Federal Thrift program which is like five giant index funds of five asset classes. I dont think they have any activism. But some top federal official could polticize them like you-know-who who often disparages individual companies and perhaps ask for the sale of a large amount of stock.
darawk 8y ago
> Limit the voting power of corporate shares held by index managers. But such a step would, in substance, transfer voting rights from corporate stock owners, who care about the long-term, to corporate stock renters, who do not... an absurd outcome. This sounds like the most viable strategy to me. Just don't let index funds vote. I don't understand his objection at all. The index fund managers are not long term investors in these corporations. The people who own the index's shares are, and they are deferring their votes to the managers right now.
- walshemj 8y ago
  How long has AT&T been in the dow jones index or IBM or Coca Cola ?
  - darawk 8y ago
    A long time. What are you getting at?
    - walshemj 8y ago
      So index funds would have to hold AT&T long term.
      - darawk 8y ago
        Did you read what I said about that? > The index fund managers are not long term investors in these corporations. The people who own the index's shares are, and they are deferring their votes to the managers right now.
- xkjkls 8y ago
  Exactly. Once an index fund is making active decisions about the management of a company, it's no longer a passive investment vehicle (though they never really are in the first place, given indexes like the S&P 500 are decided by a committee).
chanakya 8y ago
I don't understand why this is a problem. The actions of index fund managers are constrained enough to be almost automatic (hence the rock bottom fees). They just balance the portfolio to track an index. With this constraint, how does it give them power over corporations?
njarboe 8y ago
> Force giant index funds to spin off their assets into a number of separate entities, each independently managed. Such a drastic step would—and should—face near-insurmountable obstacles, for it would create havoc for index investors and managers alike. Set a cap of $1 trillion or $500 billion that any single firm can have under management. This probably only breaks up Vanguard and BlackRock. Not sure how this would cause havoc. Seems like we need to relearn the reason anti-trust laws we passed in the US and start using them again. I do think Vanguard has been a great boon for American investors and would not like them punished for their success. Not sure how to square that fact with the need to break them up.
hartator 8y ago
Author complains about high barrier of entry to create a new index fund, but all solutions he list are just even more barriers of entry. The common sense of not putting new laws until clear evil has been observed should be applied here.
- yborg 8y ago
  >the common sense of waiting for a massive crisis before doing something by which time it is too late for millions of investors who lose everything That is the conventional approach, I think Mr. Bogle is suggesting that we act to prevent such issues ahead of time for a change. And the main barrier to entry he refers to is essentially the size of the established players. They have economies of scale that a new entrant would be hard-pressed to match. And the author is the man who essentially invented the index fund, and whose company, Vanguard, currently is the market leader in these products and has the most to gain from maintaining the status quo.
pedrocr 8y ago
This seems quite easy to fix. Just give me the option of voting my shares in the underlying companies of the index funds I own. I just want to own the market average but I'm happy to be an activist investor in the decisions I happen to care about. Index funds may even want to differentiate themselves by having good research teams to advise me on what to decide and having convenience options where I get to set specific generic voting policies that they will then implement automatically for me.
- walamaking 8y ago
  Have you ever voted before? Assume 10 questions per company. Exposure to S&P 500 would mean 5,000 questions to answer. I don't know what the general stats are, but some proxies I've seen have 20+ questions. Now, you will most likely be uninformed about most of the decisions that need to be made, which lead to your 2nd point about default options suggested by the index fund manager. But that just circles back to Bogle's points in the article. Also, with index fund costs at rock bottoms, good luck getting quality research into your voting options.
  - pedrocr 8y ago
    > But that just circles back to Bogle's points in the article. Also, with index fund costs at rock bottoms, good luck getting quality research into your voting options. The alternative is active funds where you're already paying for exactly the same thing plus a bunch of compensation for underperformance to people who pretend to know what they're doing. Paying a research team is cheap in comparison and once funds are at <0.10% expense ratios making them cheaper isn't that big of a market advantage anyway. A good research team and interface would definitely make me pick a 0.10% fund over a 0.05% one for a life-long investment career. If I'm reading the numbers in the article correctly at the scale of Vanguard that's a cool billion dollars a year to provide research and systems.
randyrand 8y ago
If I own a 1000 shares of an index fund, (which maybe includes 3 shares of AAPL or something) shouldn't the 3 shares of voting power go to me? Why not?
viburnum 8y ago
Now that everything is getting rolled up into index funds, might as well just turn over the means of production to the workers.
thoughtstheseus 8y ago
Well, significant amounts of assets will be essentially controlled (votes) by people who do not own it...

228 points by scdoshi 8y ago

Maybe I'm misunderstanding something, because I find it odd to hear this from Bogle himself. Vanguard doesn't own or control the equities in their index funds. You do. Vanguard is structured so that you can own your piece of the index fund pie. And while there are large holders of index funds such as Vanguard's Total Stock Market fund, I don't think there are any majority holders. For 51% of equities to be channeled through Vanguard but owned by stockholders does not seem to be a risk. If I'm wrong, can you explain what I'm wrong about?

jonbarker 8y ago
The risk is that Vanguard, State Street, and Blackrock, employ small 'governance teams' whose job is to vote on your behalf. Since they don't have an explicit fiduciary duty to the shareholders of the index funds, but do have an implicit one, it can be argued that you don't actually have a vote in how the component companies are run. More here: https://outline.com/njXPEu https://outline.com/njXPEu
- jschwartzi 8y ago
  Vanguard explicitly asks you to vote your shares. I've gotten letters in the past asking me to cast a vote.
  - travisp 8y ago
    Vote on mutual fund governance questions. Not on each of the thousands of companies that the fund is invested in.
  - jonknee 8y ago
    You do not get 3,641 letters asking you to vote in each of the companies that make up VTI. If you own shares of a company directly you will get a letter and you may get a letter about governance of the fund you own, but not for the individual names in it (you own a piece of something that owns the actual shares).
clairity 8y ago
the issue arises because typically the fund acts as your proxy when it comes to voting rights (most index investors are looking for a reliable and easy return, not a voice in corporate governance).
deleted 8y ago
[deleted]
chmaynard 8y ago
> Vanguard doesn't own or control the equities in their index funds. You do. Is this statement correct? Your argument hinges on it, so it's important to get a definitive answer.
- privateSFacct 8y ago
  No it is not. It is 100% false with respect to voting rights. The most visible sign of Vanguard’s engaged ownership is our funds’ proxy voting at shareholder meetings. We have an experienced group of analysts on our Investment Stewardship team that evaluates proposals and casts our funds’ votes in accordance with our voting guidelines. Fund holders do not vote on corporate issues of stocks held by vanguard. And of course, the owner of stocks held by a mutual fund are the mutual fund. Is that not clear to most people?

gregorymichael 8y ago

A bit click-baity, but the warning here from the father-of-index-funds is not that they've become a bad investment, but that their popularity is leading toward a handful of financial institutions holding controlling interests in most of the largest companies. Pretty interesting unitended consequence.

fitchjo 8y ago
He is mentioned here pretty regularly, so many may already be aware, but Matt Levine discusses this and its variants a lot in his newsletter, most of the time under the heading "Should index funds be illegal?"
sseveran 8y ago
I have a hard time seeing it as unintended. If you are not promising any differentiation between yourself and the index than the only thing to really compete on is cost. There are economies of scale in finance, specifically if you need to optimize solely for AUM.
- davio 8y ago
  There's definitely a race to the bottom going on with the free Fidelity funds and Vanguard reducing the dollar minimum by 70% for a lot of admiral shares.
  - barrow-rider 8y ago
    Vanguard is doing "Auto" Admiral too -- if you meet the 3k minimums for Admiral funds they're auto converting you anyway. Race to the bottom or not, competition works.
  - refurb 8y ago
    Yet another great example of "race to the bottom" benefiting consumers. Not sure why it's used in a negative way all the time.
    - 8y ago

brianliou91 8y ago

This is fascinating. Selfishly though this seems to signal for investors of index funds (such as myself) that they will only continue to be good investments unless major government regulation occurs. Does anyone know of any investment risk to index funds if everyone is now doing it?

ams6110 8y ago
I don't consider myself very savvy in investing, but I guess if "half of all stocks" are owned by index funds that's a concentration of ownership that might be considered unnatural at best. I didn't read past the paywall but one good thing if more and more people own index funds then they are participating in the success of those corporations represented in that index. Might tend to tone down some of the shrill agitation that everything "corporations" do is evil and greedy.
pge 8y ago
one risk is that if too many people are invested in index funds (passive, not buying or selling based on new information), then the price of those stocks is determined by a small group of active investors
- bluGill 8y ago
  So long as the pool is large enough that doesn't matter. Index funds just need the price to be close to reasonable to work out. When the price is not reasonable index funds do well. In general active investors work to push the price to reasonable levels. Of course there is such a thing as price manipulation which active investors can try - if there are only a few and they work together this can work out. However the investors have incentive to cheat when working together as the cheater wins against his peers, thus this currently is confined to "penny stocks" (for example the company behind the stock doesn't exist anymore but they didn't properly delist their stock so technically it can be traded - you can buy such stocks for say a penny each and then hype them to suckers as the next big thing and sell for 10 cents each and make a killing - since the company doesn't exist no one else pays attention and the scam works.)
8y ago

cs702 8y ago

If the stock market becomes dominated by copycats copying each other, can it price equity risk accurately?

notacoward 8y ago
> can it price equity risk accurately? When was the last time they did that anyway? Or tried? For a while, Wall Street has been more interested in predictability or volatility than in actual risk. They flat-out don't care whether an investment will tank, so long as they can predict (or sometimes even control) the timing. Or use some minute technological advantage to reap the rewards before someone else does. The very nature of hedge funds is to be good at measuring potential arbitrage rewards, not actual risk. Copycat behavior only exacerbates a problem that already existed.
et2o 8y ago
Sure, as long as there are some individuals or firms who are not invested into index funds. Theoretically they might even prefer this situation, since if they can accurately price equity risk they will make more money if everyone else is wrong.
nabla9 8y ago
As long as there are at least some active investors left they can, because they follow price changes set by active investors passively. If index funds start to create systematic valuation errors, active strategies start to perform better and they start to outperform index funds. This is not the case, because index funds beat active fund management constantly over longer periods. (The article raises concerns of corporate governance and accumulation of power that is different issue). Matt Levine https://www.bloomberg.com/opinion/articles/2016-08-24/are-index-funds-communist https://www.bloomberg.com/opinion/articles/2016-08-24/are-in... >there is an alternative view that the rise of passive investing will improve capital allocation, because bad active investors will be driven out but good ones will remain. The passive investors can't influence relative prices, since they just buy the market portfolio, meaning that the fewer but better active investors will continue to make the capital allocation decisions. On this view, lower returns to active management are a sign that prices are more efficient and capital allocation is getting better

decimalst-s 8y ago

Is there anything legally preventing these funds from having some kind of system where you have fractional voting rights proportional to your number of shares in the mutual fund vs. the weight of the company in the index it represent? e.g. You have 100 shares of a mutual fund that has 1% of its holdings in some company- thus you have 1 vote for that company's shareholder ballot, or whatever the fractional representation based on market cap would come out to. I'm not sure if a single holder of funds can cast "partial votes" in each direction though. Either way, it seems like a problem that could be fixed through technology.

et2o 8y ago
They could even just hold their own internal vote immediately before the actual vote and net out the results. Then vote this result in the actual vote. I don't think there is a rule that if you vote, you must vote with every share. Also gets rid of any issues of fractional voting; they can track fractional votes in the internal vote, and then just round the result in the actual vote. The biggest problem is that generally index funds try to take a pretty passive approach to management decisions (although they do vote in some circumstances). If the index funds allow their investors to vote on everything, to some extent they stop being an index fund that passively tracks the market.
- justin66 8y ago
  > If the index funds allow their investors to vote on everything, to some extent they stop being an index fund that passively tracks the market. That doesn't really follow. Tracking the index and voting are two separate concerns. That's part of the point of Bogle's objections (I think - I can't read the article, I can only read about it), that they're involved in management already, even though that's not part of their mission. Simply voting based on a proxy vote of the fund's shareholders is arguably more "passive" for the fund management than what they're doing now, if you're concerned about passiveness.
  - et2o 8y ago
    I have to disagree. > Tracking the index and voting are two separate concerns I do not believe this is really true. The entire point of exercising shareholder rights by voting is to improve the performance of the company. A shareholder's decisions might be right (improved stock value) or wrong (reduced stock value), but you can't argue that it's passive involvement in the company. Changes in a company's stock price will necessarily cause changes in the index that the index fund tracks. Now, let's consider the point of an index fund with a passive investment strategy: the goal is to remove the need to make decisions in how a company operates and leave that to the better-informed investors and marketplace as a whole. Index funds in the ideal world simply want to ride along with what decisions the marketplace is making in the companies that the index tracks. This is an important tension that really cannot be resolved if index funds are to be considered passive and also vote. In practice, the votes made my index funds tend to be (thus far) ones that are on less controversial issues like best practices for management, etc. You don't see Vanguard pushing for mergers or spinoffs like Carl Icahn would try to do. However, in principle all shareholder votes exist on some continuum of activist investing.

ajmurmann 8y ago

A while ago some article had a great example of what can happen if the majority of shares of most companies in the same industry are held by the same investors: It punishes competition within the same industry. The example was about the airline industry where investors don't want airlines to go head to head on pricing. While some companies might benefit from this, it would lead to lower margins and thus profits for the industry as a whole. So this in essence might form a cartel.

zAy0LfpBZLC8mAC 8y ago

(Index) funds solve a problem that we shouldn't really have anymore. The problem is that (semi) manually trading securities is inherently expensive. Funds solve that problem by massively reducing the number of transactions that are required: 1000 people investing in a fund investing in 1000 companies needs 2000 transactions instead of the 1000000 transactions needed when 1000 people invest in 1000 companies directly. But there really is no fundamental reason anymore why you shouldn't be able to just buy small numbers of shares from a thousand companies via electronic systems. A million transactions is not really a problem for modern IT, nor is managing 1000 positions in your account. Yes, there are some more practical problems (the valuation of individual stocks being too high for small investors to buy even a single one, preventing front running on index changes, tax refunds, ...) - but I would think all of those should be possible to solve in a way that is both economically feasible and has the individual investor holding the actual stock to prevent those accumulations of power. And you still could have the possibility to delegate your voting rights to some organization you trust--but that could be decoupled from the investment "product" or account itself, plus you wouldn't be required to delegate the power for all your investments. Or we could just make laws that mandate that funds must delegate voting rights to their investors, i.e., make it as if they were holding the stocks directly in that regard?

dumb_troll 8y ago
What about the problem that retail investors necessarily don't have good insights about individual companies (or stock pickers) but still want to benefit from economic growth?
- zAy0LfpBZLC8mAC 8y ago
  Yeah, what about that? They get the same overall investment strategy as an index fund, just without the concentration of power?!
mcguire 8y ago
Tracking the index on your own would be more than a full time job. You could do it automatically, but that just reinvents the fund The S&P500 had 500 stocks. Do you want to vote ~1.5 times a day?

brootstrap 8y ago

Interesting. I've heard these warning signals before about index funds. Lets just hope index funds stay healthy for another say 60 years so i can fully utilize all the $$ I am dumping into the market now in my 20s. Please??

djohnston 8y ago
i thought an index fund's health depends on the health of the companies inside it. even if people decided they wanted to replace their index funds with direct stock purchases they managed themselves, the underlying value of the fund wouldn't change right?

turc1656 8y ago

I work in this industry. I'm on the indexing side of it, not the ETF/fund side. We obviously have relationships with all the major fund providers, especially the three big names mentioned in the article. And I happen to work for the big dog - S&P. "Why? Partly because of two high barriers to entry: the huge scale enjoyed by the big indexers would be difficult to replicate by new entrants; and index fund prices (their expense ratios, or fees) have been driven to commodity-like levels, even to zero." I can attest that is absolutely 100% true. This business structure is perfect when economies of scale come into play. And S&P is a master of this. It's extremely difficult for others to compete with us because, like everything else, there is a range of services/quality. S&P is at the top end - the Mercedes of index providers. People pay more, but they get the best service/products. The margins are extremely high for any business. But for an service that is considered to have been "commoditized" (and it has to a large extent), our margins are insane. All our competitors want to attack those margins but they have trouble because they aren't able to provide the quality, variety, or depth of service that we do. Which leaves them only able to charge much less and be on the lower end of pricing. Time and time again I've seen some clients leave to go with someone cheaper and become displeased and end up coming back. That's because they simply don't have the internal systems, data contracts, or expertise from having been doing this for as long as we have. Another thing is that the business model in general is damn near unbeatable. The 500 and DJIA combined require very little work overall as they are just two out of thousands of products we have. But they account for hundreds of millions of dollars in revenue. That's sort of like having a hit movie or book. But the difference with this business model as opposed to most other areas of capitalism is that the revenue is recurring. No where else have I seen unpatented, non-copyrighted intellectual property retain its value like this. Usually there is a surge at the start and then it tapers off fast after release/purchase. That creates a cash cow which they use to build stronger infrastructure and stay at the top. That being said, let me address the main concern of the article - the issue of ownership for the index funds (not the index providers). I might very well be missing something here, but the answer seems obvious to me. They should just update the law so that the shares owned by the fund providers aren't considered theirs but rather the end holders of the ETFs/funds that they are packaged into. In fact this is so obvious to me I don't understand how it's not already the law since that's the case for a lot of other things like this. If you have a Charles Schwab account and issue an order for a buy, they buy it for you by placing the order under their trading ID on the market. You are later updated to be a holder of record during the trade settlement process. Schwab is a service/pass-through agent. It's very similar for the fund providers. They just buy the shares to package/securitize in advance and then sell to someone. This is the creation/redemption aspect of ETF management. When the creation/redemption process goes on or ETF shares change hands, a process similar to becoming a holder of record through trade settlement should occur. Yes, that would result in you technically being listed as owner of a fractional amount of shares, but that's a hell of a lot better (and easier to deal with) than saying that the fund provider owns all the shares and you just trust them to vote properly for you.

btown 8y ago

https://outline.com/DGK9Td https://outline.com/DGK9Td

kjw 8y ago

Related to this, supervoting shares are popular with tech startups that are going public, but the street generally frowns upon these structures from a corporate governance perspective. Founders pitch supervoting control as a way to make sure the company can realize its long term potential by protecting themselves from activist investors with a short term view. So far, ownership of new IPOs hasn't been affected much due to their small market caps and subsequent miniscule weighting in indices. It will be interesting to see if increasing concentrated ownership by index funds may eventually play a factor and perhaps increase acceptance of supervoting.

pdog 8y ago

Of the proposed solutions, some combination of the following three items would be a solid first step (incremental without being too drastic): * Full public disclosure by index funds of their voting policies and public documentation of each engagement with corporate managers. * Require index funds to retain an independent supervisory board with full responsibility for all decisions regarding corporate governance. * Make it clear that directors of index funds and other large money managers have a fiduciary duty to vote solely in the interest of the funds’ shareholders.

xkjkls 8y ago
> Make it clear that directors of index funds and other large money managers have a fiduciary duty to vote solely in the interest of the funds’ shareholders. That's easy to say, but deciding what the shareholders interest is can be incredibly difficult. On any difficult decision, like "should this merger be approved", index funds taking any position is the same as active management.

fipple 8y ago

The summary: if Coke and Pepsi are owned by different guys, Coke will take an action that makes them an additional $1 million, even if (especially if) it causes Pepsi to lose $1 billion. Most commonly, cut prices. If the two companies are owned by the same guy, they have the incentive not to compete with each other since their owner cares about the sum of their profits. This is why one wouldn’t be allowed to acquire the other. But the effect is the same when a single index fund owns a large chunk of both companies. The companies are encouraged to compete not too fiercely with each other.

Glyptodon 8y ago
Even without index funds the drive towards large portfolios and diversification would do the same thing. I'd go so far as to say that unified ownership of competing firms by large investors is just unhealthy in general. Not really sure what can be done about it though since many companies are rather multi-industry.
- fipple 8y ago
  Well the idea of an index, whether done through a fund or not, is to buy some of each company. A value investing approach would be to find the better stock and invest in it, so Coke stockholders would rarely own Pepsi stock and vice versa.
  - Glyptodon 8y ago
    Still, even without index funds, the first thing most people are told is that diversification is key and that sector allocation matters more than the specific companies you hold. Plus people want to mitigate risk, so they buy a little of each thing that matches whatever profile, and soon a sector essentially has unified ownership interests rather than competitive (and antagonistic) ownership interests.
- guelo 8y ago
  If all the companies in an industry are owned by the same entity couldn't they be considered one company and then monopoly regulations would apply?

empath75 8y ago

> "There is no America, there is no democracy, there is only IBM and ITT and AT&T and DuPont, Dow, Union Carbide, and Exxon … The world is a college of corporations inexorably determined by the immutable bylaws of business. The world is a business, Mr. Beale, it has been since man crawled out of the slime. And our children will live, Mr. Beale, to see that perfect world in which there’s no war or famine, oppression or brutality. One vast and ecumenical holding company for whom all men will work to serve the common good, in which all men will hold a share of stock, all necessities provided, all anxieties tranquilized, all boredom amused." Network -- 1976

apo 8y ago

He also warned in 2017: Bogle noted that trading would dry up if the stock market comprised only indexers and there were no active investors setting prices on individual issues. Everyone would just buy or sell the market. ... Shareholders of index funds could then suffer more than owners of actively managed funds, and they could take their losses harder due to the perceived security they feel precisely because they merely own the market and aren’t trying to beat it. That might make active investors feel a bit of schadenfreude for indexers who have been free-riding at their expense, but the feeling probably wouldn’t last. The greater price swings that could ensue in a heavily indexed, less-active market are likely to exacerbate losses for everyone. https://www.marketwatch.com/story/john-bogle-has-a-warning-for-index-fund-investors-2017-06-01 https://www.marketwatch.com/story/john-bogle-has-a-warning-f... It seems a good bet that this warning, like most pre-downturn warnings, will only become obvious during the next major downturn.

peter303 8y ago

He didnt mention Federal Thrift program which is like five giant index funds of five asset classes. I dont think they have any activism. But some top federal official could polticize them like you-know-who who often disparages individual companies and perhaps ask for the sale of a large amount of stock.

darawk 8y ago

> Limit the voting power of corporate shares held by index managers. But such a step would, in substance, transfer voting rights from corporate stock owners, who care about the long-term, to corporate stock renters, who do not... an absurd outcome. This sounds like the most viable strategy to me. Just don't let index funds vote. I don't understand his objection at all. The index fund managers are not long term investors in these corporations. The people who own the index's shares are, and they are deferring their votes to the managers right now.

walshemj 8y ago
How long has AT&T been in the dow jones index or IBM or Coca Cola ?
- darawk 8y ago
  A long time. What are you getting at?
  - walshemj 8y ago
    So index funds would have to hold AT&T long term.
    - darawk 8y ago
      Did you read what I said about that? > The index fund managers are not long term investors in these corporations. The people who own the index's shares are, and they are deferring their votes to the managers right now.
xkjkls 8y ago
Exactly. Once an index fund is making active decisions about the management of a company, it's no longer a passive investment vehicle (though they never really are in the first place, given indexes like the S&P 500 are decided by a committee).

chanakya 8y ago

I don't understand why this is a problem. The actions of index fund managers are constrained enough to be almost automatic (hence the rock bottom fees). They just balance the portfolio to track an index. With this constraint, how does it give them power over corporations?

njarboe 8y ago

> Force giant index funds to spin off their assets into a number of separate entities, each independently managed. Such a drastic step would—and should—face near-insurmountable obstacles, for it would create havoc for index investors and managers alike. Set a cap of $1 trillion or $500 billion that any single firm can have under management. This probably only breaks up Vanguard and BlackRock. Not sure how this would cause havoc. Seems like we need to relearn the reason anti-trust laws we passed in the US and start using them again. I do think Vanguard has been a great boon for American investors and would not like them punished for their success. Not sure how to square that fact with the need to break them up.

hartator 8y ago

Author complains about high barrier of entry to create a new index fund, but all solutions he list are just even more barriers of entry. The common sense of not putting new laws until clear evil has been observed should be applied here.

yborg 8y ago
>the common sense of waiting for a massive crisis before doing something by which time it is too late for millions of investors who lose everything That is the conventional approach, I think Mr. Bogle is suggesting that we act to prevent such issues ahead of time for a change. And the main barrier to entry he refers to is essentially the size of the established players. They have economies of scale that a new entrant would be hard-pressed to match. And the author is the man who essentially invented the index fund, and whose company, Vanguard, currently is the market leader in these products and has the most to gain from maintaining the status quo.

pedrocr 8y ago

This seems quite easy to fix. Just give me the option of voting my shares in the underlying companies of the index funds I own. I just want to own the market average but I'm happy to be an activist investor in the decisions I happen to care about. Index funds may even want to differentiate themselves by having good research teams to advise me on what to decide and having convenience options where I get to set specific generic voting policies that they will then implement automatically for me.

walamaking 8y ago
Have you ever voted before? Assume 10 questions per company. Exposure to S&P 500 would mean 5,000 questions to answer. I don't know what the general stats are, but some proxies I've seen have 20+ questions. Now, you will most likely be uninformed about most of the decisions that need to be made, which lead to your 2nd point about default options suggested by the index fund manager. But that just circles back to Bogle's points in the article. Also, with index fund costs at rock bottoms, good luck getting quality research into your voting options.
- pedrocr 8y ago
  > But that just circles back to Bogle's points in the article. Also, with index fund costs at rock bottoms, good luck getting quality research into your voting options. The alternative is active funds where you're already paying for exactly the same thing plus a bunch of compensation for underperformance to people who pretend to know what they're doing. Paying a research team is cheap in comparison and once funds are at <0.10% expense ratios making them cheaper isn't that big of a market advantage anyway. A good research team and interface would definitely make me pick a 0.10% fund over a 0.05% one for a life-long investment career. If I'm reading the numbers in the article correctly at the scale of Vanguard that's a cool billion dollars a year to provide research and systems.

randyrand 8y ago

If I own a 1000 shares of an index fund, (which maybe includes 3 shares of AAPL or something) shouldn't the 3 shares of voting power go to me? Why not?

viburnum 8y ago

Now that everything is getting rolled up into index funds, might as well just turn over the means of production to the workers.

thoughtstheseus 8y ago

Well, significant amounts of assets will be essentially controlled (votes) by people who do not own it...