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Hidden Dangers of the Great Index Fund Takeover
- adaisadais 7y agoWhile this seems (incredibly) scary it makes me think that this could be a huge opportunity for entrepreneurs (and some are currently undertaking it). The fintech entrepreneur can carefully paint the picture of the dangers of the big 3 while advocating for smaller index funds for a smaller set of investors. This smaller set of investors can have stocks based on their individual goals and interests. You just duplicate this over a lot more funds. The returns won’t be as high initially but if the entrepreneur can convince customers that this must be done it should help spurn new markets towards sustainability or carbon reduction etc. Edit: plz tell me if I totally misunderstood the article.
- toomuchtodo 7y agoYou just described M1 Finance (custom funds users can construct). Google Warren Buffett’s Long Bet about passive vs active fund management (he won the passive argument). Even sophisticated active investors are having a tremendously difficult time achieving passive returns net fees. If you’re not a sophisticated investor, I’d implore you to be cognizant of the challenges you’ll face attempting active investment strategies, especially if you’re investing retirement funds. Passive index investing might not be perfect, but it seems to be the least worst option when evaluating fund costs and risk adjusted returns, and we’re aways off from significant second order effects.
- pishpash 7y agoThere are other use cases than returns, sometimes it has to do with availability of funds or tax issues that constrain the possibilities. Even something as simple as the full spectrum of risk tolerances and time-horizons isn't well served by existing index retirement funds (they all skew to be highly risky and equity focused). It's better to have the running of an index fund be a separate service from the selection of its holdings or the choosing of goals. Right now if you have a slightly different goal than the horde, you can only go to expensive active funds, advisors, or spend a great deal of time self-managing.
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- throwawayhhakdl 7y agoI think the opportunity lies in the other direction. Say that fund managers for index funds aren’t generally accountable for performance (assuming they actually comply with the index. Differentiate the funds on their voting strategy. I don’t really give a crap about my investments if they’re well diversified across large US companies. But I would 100% prefer a fund that promised to vote for climate and civil rights issues.
- stanferder 7y agoIsn't it possible for the index funds to simply not wield the power they have, and abstain from every vote? I was surprised that funds that are not actively managed are still actively engaging with public companies.
- rileymat2 7y agoI don't know how votes are counted, but will that make it impossible to make positive changes? Or if they are not part of the total count, allow a minority of shareholders to vote against the fund's interests?
- stanferder 7y ago> [W]ill that make it impossible to make positive changes? Yes, but that's consistent with the passive philosophy at the heart of index investing. I was surprised that index funds had an active interest in anything beyond reducing fees to customers.
- pishpash 7y agoThis makes a lot of sense, actually. But it is difficult to define what is passive vs. active, and there will be many loopholes to create "activity".
- hogFeast 7y agoNo. The point of owning a share is that you own part of a business. But, functionally, this isn't what index funds are doing. They employ next to no-one with any actual investment ability (from what I have seen, they employ an unusually high number of people with political connections/bank "product" types). The problem is that this isn't really what the stock market is for. It has been turned into this infinite liquidity machine where ownership churns rapidly when the "point" is owning a business, stewardship of your asset, slow turnover (there isn't an easy solution because this is largely a supply situation, if you create a savings system that is based on the value of the stock market...it is hard not to end up here). Btw, the issue with corporate governance is far broader than this too. Even before index funds, the system was totally fucked. You had boards stocked full of know-nothings with no stake in the company. Managers were already totally unaccountable, now even more so (this is why activism is taking off, the level of corporate waste/overpaying for executives is staggering).
- kds3 7y ago> Index funds “are great for investors,” says Elhauge, “but part of the reason they’re great for investors is exactly because of the anti-competitive effects.” Elhauge says the trusts of the late 19th century that gave rise to today’s antitrust laws also involved a form of common shareholding. > She might want Coca-Cola to take big risks to crush Pepsi, and invest capital in new products and markets to do so. An investor who holds both, on the other hand, would prefer that Coke and Pepsi avoid price wars. So the way we can solve this problem is to outlaw shares ownership of competing companies? Seems like a fair solution.
- ellisv 7y ago> So the way we can solve this problem is to outlaw shares ownership of competing companies? Seems like a fair solution. This just isn't practical. What if I'm invested in Big Bank and Big Tech Co. but then Big Tech Co. creates a wallet app and credit card -- do I have to sell my ownership in one of these companies? As an investor I definitely want to own companies that compete because I don't know which one is going to prevail. Owning just one of the companies doesn't really fix the problem either -- if I own only Pepsi does that mean I would want them to get into a price war with Coke?
- kds3 7y ago> do I have to sell my ownership in one of these companies? No, company would have to split itself (create separated business entity) so you would have to sell your competing part of the company. Such a change can also solve problem of companies using their dominant/monopolistic position in one business area to get unfair advantage in another. > As an investor I definitely want to own companies that compete because I don't know which one is going to prevail. That's the problem article describes! Such behavior reduces competition and hurts customers: >> This line of research began with a 2014 paper about competition among U.S. airlines that quietly shook the fund industry and the antitrust world. José Azar, an economist at the University of Navarra in Barcelona, along with Martin Schmalz and Isabel Tecu, showed that airline ticket prices were 3% to 7% higher because big funds owned stakes in so many airlines.
- darawk 7y agoThe extremely simple and correct solution here is to not let index funds themselves vote. Only allow the votes to be cast directly by the index share holders. Problem solved, I don't know why people keep hand wringing about this and not suggesting the supremely obvious solution here.
- enraged_camel 7y agoSolutions to complex problems are rarely simple or obvious.
- stingraycharles 7y agoMore precisely, it might be simple but not easy: it’ll be quite difficult an operation to collect votes from the tens of thousands of shareholders of the funds, and votes are happening all the time on a global scale.
- lifeisstillgood 7y agoI remember trying to build just this solution about a dozen years ago - the SWIFT integration was achievable but the main stumbling block was it seemed like a marketplace buildout - you needed to get everyone persuaded it was a good idea before it takes off. Things may have changed
- ellisv 7y ago> The extremely simple and correct solution here is to not let index funds themselves vote. Only allow the votes to be cast directly by the index share holders. Problem solved, I don't know why people keep hand wringing about this and not suggesting the supremely obvious solution here. Something like create a super-voting share class for active investors and regular stock for the index funds? https://en.wikipedia.org/wiki/Super-voting_stock https://en.wikipedia.org/wiki/Super-voting_stock
- roenxi 7y agoAn interesting idea, but not appropriate in this instance. Super-voting stock are basically a polite way of retaining control while not appearing to own a majority of shares. They don't preserve the right incentive structure and remove escape valves the regular stock holders should enjoy. I thought the original idea here is to let the index investors direct the fund how to vote with their portion of the index's stock. A pretty neat idea that de-fangs much of the incentive risk if the index fund management goes rogue or an activist investor tries something.
- chrisstu 7y agoI think there’s a bigger issue with passive inversing. Once an equity is in a cap weighted index like the S&P 500 with a high weighting, like Apple, can’t we end up in a situation where the individual company performance is irrelevant? Nobody will sell Apple because they just own it through their SP500 fund. As long as they are buying and holding the index fund, Apple remains at a high valuation. The only thing that differentiates individual stocks is active investors. And as they make up a smaller and smaller fraction of over investment, they become less relevant.
- pfortuny 7y agoI guess inflation and interest rates play a non-negligible role there.
- zozbot234 7y agoAnd as active investors become less relevant in the market, their returns will increase bringing the situation back into balance. Dumb money gets fleeced.
- javagram 7y agoAAPL and similar stocks do show their share price changing in response to financial announcements, sales numbers, etc. This concern is valid but I believe it only prevents price movement once a much larger majority of the market is passively managed.
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- wutbrodo 7y agoI don't think it'd be much of a concern at a larger scale either. I stopped actively investing a long time ago because it wasn't worth my time, but if the market got to the point where it was responsive to reality, the increased returns would probably draw me back in. And before me would be institutional investors, picking up ~free returns. The system is designed to be self-equilibriating in this respect
- 7y ago
- hughpeters 7y agoThis is such a fascinating problem. On the one hand Jack Bogle's invention of the index fund has been so good for retail investors but because the process currently requires a middle man - i.e. one of the big three - these index funds have slowly become bloated with power. What if the algorithm Vanguard uses was open sourced and could be self-hosted by independent investors? Where each investor owns their portfolio outright and adjustments to the portfolio are made automatically by a free index manager bot that runs the simple algorithm an index fund manager like Vanguard would. Why wouldn't something like that work?
- Forge36 7y agoHaving spoken with few people, the process is still mostly people, building algorithms in Excel. Much of what drives decisions is research, and personal decision's, not automation. I've heard AI trading has done very poorly as the system isn't predictable, it's people making decisions in ways which can become self fulfilling prophesies. Algorithms when distributed would also fall victim to the fastest person benefiting the most
- echelon 7y agoWhat sorts of things do you track and model in Excel? I've been looking at fundamentals and the business landscape. What should I add?
- dkarras 7y agoBut this is not supposedly true for index funds by definition. They are passive. They just buy whatever is in the index. No other decisions made.
- biggestdecision 7y agoAn index fund isn't doing research or making decisions though. They invest in companies that make up an index. When a company enters the index they buy units in that company, when a company leaves the index they sell those units.
- kqr 7y ago
- pochamago 7y agoI think at some point we'll hit a saturation point on passively managed funds. What they're really doing is edging out the non profitable actively managed funds, and forcing managers to prove they can beat the market if they want investment. I also think we'll see more brokerages starting their own indices, which will lessen the power of any individual fund
- nitrogen 7y agoI also think we'll see more brokerages starting their own indices, which will lessen the power of any individual fund This seems to be happening with ETFs
- kccqzy 7y agoWell think of it this way. Since index funds replicate the market exactly, then the non-index funds also on average replicate the market. It's just some funds beat the market while others underperform.
- jcrben 7y agoNo. In theory we could have just two active (non-index) managers, and their average returns certainly would not replicate the market.
- jl2718 7y agoGiant organization overseeing a huge number of competing interests and accountable by proxy to millions of individual shareholders. This sounds like a government. Maybe we’ll see voting for representatives and parties.
- vanniv 7y agoAre we really supposed to get excited about Bloomberg whining about the evils of index funds?
- thedudeabides5 7y agoHow about the danger of three corporations being responsible for liquidity in 30% of these shares. What happens if one of these companies goes down, and with it, a need to liquidate 8% of Apple in a single day?