Author Topic: FT: Hidden Dangers of Passive Investing  (Read 3897 times)

Sydneystache

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FT: Hidden Dangers of Passive Investing
« on: July 02, 2017, 10:54:20 PM »
Article earlier this year from the FT - I think it was to counter when Blackrock came out and said how PI is great for society.

Thoughts? The oligopoly is a concern...

https://www.ft.com/content/15dd3552-3fad-11e7-82b6-896b95f30f58

30 May 2017

"A cure-all. This is what passive investing represents to its growing band of proponents. Equity tracker funds, we’re told, will rid the financial market of toxic elements and restore it to full health. At first glance, it’s a persuasive argument. Poorly performing and expensive active managers have lingered in the system for too long, eroding returns for investors. Yet on deeper reflection, index-tracking products are no miracle remedy. They’re more like antibiotics: valuable when deployed in moderation, but likely to do more harm than good should their use become widespread.

Indeed, if passive equity funds were to continue their present growth trajectory, they would own all listed stocks by 2030. That could threaten the free-market economy. To see why, it’s necessary to look more closely at the workings of index investing and the structure of the passive fund industry.

Under index-tracking, the shares of companies with large weightings in the major indices attract more capital irrespective of their underlying performance. So in a system in which passive funds monopolise investment flows, the price of a security ceases to function as a gauge of a firm’s underlying prospects. This distorts the cost of equity and the price of credit. In such conditions, serious misallocations of capital would become the norm, creating asset bubbles on the one hand and leaving innovative firms starved of funds on the other. That wouldn’t be good for productivity or growth.

Likely to make matters much worse, though, is the concentration in the passive fund market. Essentially, the industry is an oligopoly, dominated by just three giants of asset management, who between them control almost three quarters of all passively-managed investment in stocks.

Drawing on seemingly limitless economies of scale, these investment powerhouses have been able to amass assets simply by slashing costs. And the more assets they gather, the more they can reduce fees and so continue their expansion, in contrast to active managers, whose room for manoeuvre is constrained by liquidity and therefore size.

This has major implications. As demand for index products grows, a greater proportion of the world’s listed companies will fall under the control of the three largest investment management groups. Already, these firms collectively own close to 20 per cent of US large-cap companies. Taking the commoditisation of the asset management industry to its logical conclusion, entire industries could end up being swallowed up by the big three.

And what happens when a small group of passive shareholders — investors who can’t vote with their feet — control most or all of the companies in a given industry? Two developments are likely. The first is a weakening of corporate governance standards.

The second is an erosion of competitive forces, whereby the overlapping holdings of the dominant passive shareholders create the conditions for oligopolistic corporate practices to emerge. Several recent academic studies have found that competition has diminished in industries where company shareholdings are concentrated among a small group of mostly passive investors, hurting consumers in the process.

In the US airline sector, in which the biggest firms are owned by the same large, predominantly passive institutional money managers, competition among carriers has dwindled, causing a spike in passenger air fares. A similar situation is unfolding in US banking. Here, researchers have found a strong link between the accumulation of bank shares by a small group of index fund groups and a rise in deposit account servicing fees.

A handful of other industries appear vulnerable to a passive annexation. Those that are very capital intensive or already quite concentrated, such as utilities, energy and telecommunications are among the most obvious candidates. Passive dominance won’t happen overnight. Yet, left unchecked, the growth of index-trackers has the potential to erode the market-based economy, one industry at a time.

There is also a geopolitical dimension. If the passive giants end up owning large swaths of the capital market, they will also have a big say on the composition of stock and bond indices. Effectively able to decide which country or company should be included or excluded from those benchmarks, they would wield enormous influence over international capital flows. Note BlackRock’s recent call for China to be included in MSCI’s global equity indices.

Some might see that as an excessive concentration of power.

None of this relieves the pressure on active managers to perform and offer better value to their clients. Nor does it deny the utility of passive investment. Index products offer benefits to investors. The problem is that if the majority of us embrace them, index-trackers threaten to sabotage the entire economic system. Much like antibiotics, if passive funds are overused, they will create more problems than they solve."

Renaud de Planta is chairman of Pictet Asset Management and managing partner of the Pictet Group"

misterhorsey

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Re: FT: Hidden Dangers of Passive Investing
« Reply #1 on: July 03, 2017, 12:09:45 AM »
I'm struck by how these index naysayers describe the growth of indexes as this irresistible rising tide, swallowing everything in it's wake.

Like the Borg, for Star Trek Fans.

Certainly growth in index inflows will result in a reduction of money going into active investment, and thus crimp active investment managers' margins.

But surely there will be enough investors out there who will still believe they can beat the market, and thus provide opportunities for those investors (and their well remunerated managers) that will serve as a bulwark against total index domination?  So the nightmare scenario they are dreading will never actually happen?

But perhaps this article needs to be read as pro-active marketing by active managers of their services to seize that commercial opportunity?

Islander

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Re: FT: Hidden Dangers of Passive Investing
« Reply #2 on: July 03, 2017, 04:37:24 AM »
Iam a novice investor and have very limited knowledge but from my understanding there will always be people who will try to beat the market (our human nature) so this eliminates the idea that everyone will passive invest.

YttriumNitrate

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Re: FT: Hidden Dangers of Passive Investing
« Reply #3 on: July 03, 2017, 08:22:09 AM »
People usually talk their book. Passive investors often dismiss daily financial news as just background noise, and being viewed as noise is not good for the Financial Times readership numbers.

Radagast

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Re: FT: Hidden Dangers of Passive Investing
« Reply #4 on: July 03, 2017, 08:49:01 AM »
Only Pictet Asset Management can save us now!

ChpBstrd

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Re: FT: Hidden Dangers of Passive Investing
« Reply #5 on: July 03, 2017, 01:42:11 PM »
There is something to be said for the problem of membership in an index potentially inflating an asset's value and reducing incentives for shareholder-friendly corporate governance. This could play out as excessive executive compensation or as outright fraud. Consider the issue reverse mergers, with Chinese shell companies getting onto the index and then selling a bunch of equity to our index funds. As long as they track the index, no one cares.

http://www.marketwatch.com/story/after-china-fraud-boom-nasdaq-steps-up-scrutiny-of-shady-listings-2016-06-20

Given that the benefits of diversification plateau after 30-40 stocks, constructing your own index may become more economical than paying an index fund some pittiance to make sure you have the total stock market, which would include the companies designed solely to convert shareholder equity into executive compensation and insider self-dealing.

Eric

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Re: FT: Hidden Dangers of Passive Investing
« Reply #6 on: July 03, 2017, 05:31:57 PM »
Consider the source.  Always.

bigchrisb

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Re: FT: Hidden Dangers of Passive Investing
« Reply #7 on: July 03, 2017, 07:02:08 PM »
If I were an active manager trying to exploit inefficiency in the market to generate a return, these things would excite me. Indexing starves an industry? Great, I invest. Indexing causes a bubble? Great, I go short. Happy days.

Oh. Wait. Most "active" managers are more interested in passive fees for funds under management than performance.  If I was an active manager living off fees for funds under management, I'd be starting to panic too.

triangle

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Re: FT: Hidden Dangers of Passive Investing
« Reply #8 on: July 05, 2017, 12:44:28 AM »
I do not think passive investing has caused great harms as this article claims, but I do think there are potential issues out into the future as more and more people understand how passive indexing has consistently generated better returns over time, especially when considering lower yearly fees. That there is a saturation point where blindly indexing could start to become harmful to investors.

Take the extreme example case where 99% of stock market investments are done through a total market weighted fund. In this situation the big stocks would stay on top and the small stocks always near the bottom, as the other 1% of independent buyers could not affect the index balance very much. Of course market ownership will never reach 99% indexing but at some lower level the feedback loop from indexers will slow the relative internal rebalancing within the index to a point where active buyers can take advantage of stock mispricings. The level that starts happening is much harder to speculate about, but we are not there yet.

TornWonder

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Re: FT: Hidden Dangers of Passive Investing
« Reply #9 on: July 05, 2017, 06:40:34 AM »
While I am less inclined to believe that the market will suffer some terrible fate due to the increased prevalence of passive investing, I do think there could be problems with regards to corporate governance.  By investing passively through index funds, shareholders lose the ability to vote their shares.  If >50% of as company's shares are owned by Vanguard, they will have control of the company without having any actual financial investment on their part.

GreenEggs

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Re: FT: Hidden Dangers of Passive Investing
« Reply #10 on: July 05, 2017, 07:02:23 AM »
While I am less inclined to believe that the market will suffer some terrible fate due to the increased prevalence of passive investing, I do think there could be problems with regards to corporate governance.  By investing passively through index funds, shareholders lose the ability to vote their shares.  If >50% of as company's shares are owned by Vanguard, they will have control of the company without having any actual financial investment on their part.

This has always been a concern of mine too. 

PathtoFIRE

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Re: FT: Hidden Dangers of Passive Investing
« Reply #11 on: July 05, 2017, 08:23:55 AM »
The question then becomes, is corporate governance aided or hindered by input from (multiple divergent) owners?  If anyone can point us towards any body of research on this, it would be appreciated. If not, I'll counter punditry with punditry and ask if this view, while the opposite of that posted originally, is any more or less convincing to everyone?

http://www.pragcap.com/are-index-funds-risky-for-corporate-governance/

Runge

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Re: FT: Hidden Dangers of Passive Investing
« Reply #12 on: July 05, 2017, 08:30:06 AM »
While I am less inclined to believe that the market will suffer some terrible fate due to the increased prevalence of passive investing, I do think there could be problems with regards to corporate governance.  By investing passively through index funds, shareholders lose the ability to vote their shares.  If >50% of as company's shares are owned by Vanguard, they will have control of the company without having any actual financial investment on their part.

This has always been a concern of mine too.

That's not specific to passive investing though. It's my understanding that any mutual fund, active or passive, requires the investor to handover voting privileges to the mutual fund company.

What AUM would any one investment company have to have to reach the point where they begin to own more than 50% of a large number of companies solely from passive investing? Assuming said companies even allow for one investment company to own a majority stake...


Side note...
Here's Vangards proxy voting guidelines and how each fund voted, if you're curious.
https://about.vanguard.com/investment-stewardship/
https://about.vanguard.com/investment-stewardship/voting-guidelines/
https://about.vanguard.com/investment-stewardship/how-our-funds-voted/

Basically, as I read it, Vanguard has an Investment Stewardship Oversight Committee that decides how to vote for each company under each mutual fund. Looks like they typically have all Vanguard funds vote together, but they can elect to vote differently or withhold some votes on a case by case basis for each mutual fund.

TornWonder

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Re: FT: Hidden Dangers of Passive Investing
« Reply #13 on: July 05, 2017, 11:57:45 AM »
The question then becomes, is corporate governance aided or hindered by input from (multiple divergent) owners?  If anyone can point us towards any body of research on this, it would be appreciated. If not, I'll counter punditry with punditry and ask if this view, while the opposite of that posted originally, is any more or less convincing to everyone?

http://www.pragcap.com/are-index-funds-risky-for-corporate-governance/

But another way to look at that is that it is much more difficult to bribe/coerce/corrupt a multitude of divergent owners than a single entity. 

If a CEO of poorly performing company wants to prevent their or their board's removal from the company, this makes it much easier to accomplish.  Rather than convince thousands of separate individuals with a financial stake in the company, they need only sway a handful of people with potentially no personal investment in the company.  Do you hope that these individuals are good and honest people?  Yes.  Can you trust that they are?

This problem is not restricted to index funds, but the rapid growth of index funds combined with the fact that basically three companies control almost all of them, makes it more concerning.