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.
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.<p>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.
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.
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.
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.<p>If I'm wrong, can you explain what I'm wrong about?
He also warned in 2017:<p><i>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.<p>...<p>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.</i><p><a href="https://www.marketwatch.com/story/john-bogle-has-a-warning-for-index-fund-investors-2017-06-01" rel="nofollow">https://www.marketwatch.com/story/john-bogle-has-a-warning-f...</a><p>It seems a good bet that this warning, like most pre-downturn warnings, will only become obvious during the next major downturn.
> "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."<p>Network -- 1976
Of the proposed solutions, some combination of the following three items would be a solid first step (incremental without being too drastic):<p>* Full public disclosure by index funds of their voting policies and public documentation of each engagement with corporate managers.<p>* Require index funds to retain an independent supervisory board with full responsibility for all decisions regarding corporate governance.<p>* 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.
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.<p>Does anyone know of any investment risk to index funds if everyone is now doing it?
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??
> 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.<p>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 <i>managers</i> 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.
(Index) funds solve a problem that we shouldn't really have anymore.<p>The problem is that (semi) manually trading securities is inherently expensive.<p>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.<p>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.<p>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.<p>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?
> 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.<p>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.<p>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.
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.<p>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.<p>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.
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.<p>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.
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?
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.
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?
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.<p>The common sense of not putting new laws until clear evil has been observed should be applied here.
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.<p><i>"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><p>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.<p>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 <i>recurring</i>. 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.<p>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.