Market swings: Are index funds too powerful?
“In the world of investing, it is possible to beat the market—but it takes a fair amount of work, skill, and patience,” said MotleyFool.com. The allure of index funds, which match the broader stock market rather than trying to beat the market by picking and choosing individual stocks, is clear: They beat the performance of most actively managed funds, at far lower cost. However, since they invest in the entire market, those funds don’t distinguish good companies from bad ones. Even John Bogle, the inventor of the index fund, thinks putting that much capital in the hands of index fund operators who exercise active oversight of management creates “a risk to corporate governance.” Do the biggest index funds have too much power?
Yes, they do, said John Gapper in the Financial Times. Or, at the very least, it’s something we should be scrutinizing more. “The Big Three of the U.S. industry—BlackRock, Vanguard, and State Street—have gained such size and efficiency that they control 80 percent of the money invested in U.S. index funds.” These funds are less likely to speak up and force companies to change, and can leave the work of corporate governance to “a few activists who demand quick fixes.” Funds that rely on passive investing formulas have already made market swings more severe, said Gregory Zuckerman in The Wall Street Journal. High-speed, computer-driven hedge-fund trading makes up close to 30 percent of the stock market’s volume. “Add to that passive funds, index investors, highfrequency traders, market makers, and others who aren’t buying because they have a fundamental view of a company’s prospects, and you get to around 85 percent of trading volume”—trades that are made without regard to the underlying health of the companies.
Putting too much power in the hands of passive investors doesn’t serve the national interest, said John Bogle, also in The Wall Street Journal. When I founded the first index fund in 1975, Wall Street was so skeptical of the idea that it was called “Bogle’s Folly.” It turned out to be “the most successful innovation in modern financial history.” But that success has a downside: “If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation.” Index funds must offer timely and full disclosure of their voting policies, and when they have investments in competing companies, they must not help them collude. But don’t let the problems make you forget the tremendous value of such funds. They still embody “the most effective stock-market strategy of all time: Buy American business and hold it forever, and do so at rock-bottom cost.”