Author Topic: The Index Investing Passive Problem  (Read 2637 times)

Prairie Moustache

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The Index Investing Passive Problem
« on: April 03, 2018, 01:14:02 PM »
Hi Folks,

Sorry if this has been discussed to no end, so please point me to a thread if it exists.

I hear occasional rumblings about how indexing is essentially creating a silent majority of shareholders who don't actually engage with the companies that they hold and actively influence their policies and direction. The voting power of these shares is essentially stacked behind several large ETF providers.

Does anybody else see any issues with just giving the S&P 500 companies money to essentially maintain the status quo? Obviously historic stock market performance would indicate that these companies are still being innovative/growing etc. but the recent massive uptick in money being put into ETF's might change things?

I don't hear this being discussed on the major FI blogs that I've come across so any input would be appreciated!

Cheers.

SubL stache

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Re: The Index Investing Passive Problem
« Reply #1 on: April 03, 2018, 01:55:25 PM »
Correct me if I'm wrong but the vast majority of stock transactions involve third parties purchasing shares from third parties.  So unless there is another stock offereing or an IPO you are not giving the companies any money at all, they already raised that money.

Management is tasked with creating shareholder value, the board is tasked with monitoring that goal.

I don't believe "active" retail investors have any greater participation or say about what happens than passive retail investors.  The numbers are just too small to matter.  As usual I could be wrong.

VoteCthulu

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Re: The Index Investing Passive Problem
« Reply #2 on: April 03, 2018, 02:01:10 PM »
Personally, I wouldn't be any more engaged if I owned the stocks directly.

The only real problem I foresee is if the large index funds start doing under the table deals to vote their stocks against the best interests of their investors, but that's not very high on my list of worries.

Telecaster

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Re: The Index Investing Passive Problem
« Reply #3 on: April 04, 2018, 12:01:24 AM »
Hi Folks,

Sorry if this has been discussed to no end, so please point me to a thread if it exists.

I hear occasional rumblings about how indexing is essentially creating a silent majority of shareholders who don't actually engage with the companies that they hold and actively influence their policies and direction. The voting power of these shares is essentially stacked behind several large ETF providers.

Does anybody else see any issues with just giving the S&P 500 companies money to essentially maintain the status quo? Obviously historic stock market performance would indicate that these companies are still being innovative/growing etc. but the recent massive uptick in money being put into ETF's might change things?

I don't hear this being discussed on the major FI blogs that I've come across so any input would be appreciated!

Cheers.

If you buy stock, unless it is the IPO or a secondary offering, you aren't buying from the company, you are buying it from a second party, so the company doesn't directly benefit unless your purchase causes the stock price to rise.  Corporate boards are controlled by the frat brothers and golfing buddies of the CEO anyway.  Unless you are a major shareholder, like 2-5%+ your voice is meaningless.   Also, most shareholders are stupid and are looking for short term gains.  That's exactly what you don't want.  So if there is a passive, silent majority, that's a good thing. 

That said, only about 20-30% of the market is invested in index funds.  So there are still plenty of suckers out there to do the price discovery. 

NoStacheOhio

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Re: The Index Investing Passive Problem
« Reply #4 on: April 04, 2018, 06:15:54 AM »
That said, only about 20-30% of the market is invested in index funds.  So there are still plenty of suckers out there to do the price discovery.

If I'm reading the OP correctly, it's more about corporate governance than efficient markets. It's an understandable concern, but one that you can also mitigate by holding funds with companies you feel act ethically, and in their fund participants best interests (i.e. Vanguard). I'm not sure how effective it is, but I've seen others suggest calling up your mutual fund company if you feel strongly about a particular issue, because they do vote the shares in the fund.

toganet

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Re: The Index Investing Passive Problem
« Reply #5 on: April 04, 2018, 06:26:06 AM »
If you buy stock, unless it is the IPO or a secondary offering, you aren't buying from the company, you are buying it from a second party, so the company doesn't directly benefit unless your purchase causes the stock price to rise.

(emphasis mine)

This is something I think I don't fully understand -- since post-IPO sales of stocks between third parties don't send any $$ directly to the company, in what ways do they benefit?  Is it just that a higher (or rising) stock price is indicative of faith in the company's profitability/longevity/growth, meaning they can raise capital more easily?

Stimpy

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Re: The Index Investing Passive Problem
« Reply #6 on: April 04, 2018, 07:38:24 AM »
If you buy stock, unless it is the IPO or a secondary offering, you aren't buying from the company, you are buying it from a second party, so the company doesn't directly benefit unless your purchase causes the stock price to rise.

(emphasis mine)

This is something I think I don't fully understand -- since post-IPO sales of stocks between third parties don't send any $$ directly to the company, in what ways do they benefit?  Is it just that a higher (or rising) stock price is indicative of faith in the company's profitability/longevity/growth, meaning they can raise capital more easily?

They technically don't benefit beyond the original IPO or PO.  The stock holder is an owner of the company and can have (but usually doesn't exercise) a say in how the business is run.  This can sometimes be a benefit for the holders of said stock and depending on what the shareholder pushed for can be a benefit or future hindrance for the company as well.

appleshampooid

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Re: The Index Investing Passive Problem
« Reply #7 on: April 04, 2018, 08:26:52 AM »
If you buy stock, unless it is the IPO or a secondary offering, you aren't buying from the company, you are buying it from a second party, so the company doesn't directly benefit unless your purchase causes the stock price to rise.

(emphasis mine)

This is something I think I don't fully understand -- since post-IPO sales of stocks between third parties don't send any $$ directly to the company, in what ways do they benefit?  Is it just that a higher (or rising) stock price is indicative of faith in the company's profitability/longevity/growth, meaning they can raise capital more easily?
Usually many employees hold a lot of stock, so it's at least good for them as individuals. It is good for recruiting if you offer equity as part of your package, since you can point to the stock rising.

Proud Foot

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Re: The Index Investing Passive Problem
« Reply #8 on: April 04, 2018, 08:59:10 AM »
I think it does tend to pose somewhat of a problem if the institutional holders are not active in shareholder voting.  On the flip side I would be more concerned if they tried to become too involved and take on an activist investor role. My guess is that if they do exercise their votes they most likely vote in line with the board's recommendation. Looking at Apple, the top 20 institutional holders hold around 34% of the total shares. Remove Berkshire Hathaway and it becomes 31% held by mutual funds/ETF's.  I am sure management likes it if they only vote as the board recommends as it makes it harder to make sweeping changes to the organization.

Prairie Moustache

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Re: The Index Investing Passive Problem
« Reply #9 on: April 04, 2018, 10:19:15 AM »
If you buy stock, unless it is the IPO or a secondary offering, you aren't buying from the company, you are buying it from a second party, so the company doesn't directly benefit unless your purchase causes the stock price to rise.

(emphasis mine)

This is something I think I don't fully understand -- since post-IPO sales of stocks between third parties don't send any $$ directly to the company, in what ways do they benefit?  Is it just that a higher (or rising) stock price is indicative of faith in the company's profitability/longevity/growth, meaning they can raise capital more easily?

I understand that shares are traded on the market independent of the actual activities of a company, but it comes down to how you define "benefiting" a company. I'd argue that by pumping massive amounts of money across the S&P 500 index, etc it's a positive market signal to companies to motor on business as usual. Not that this is necessarily a bad thing in some cases. I'm largely deriving this argument from an episode of Slate Money with Felix Salmon and Anna Szymanski, the episode number escapes me.

I know I'm missing some important points in my thinking here.

alanB

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Re: The Index Investing Passive Problem
« Reply #10 on: April 04, 2018, 10:37:10 AM »
If you buy stock, unless it is the IPO or a secondary offering, you aren't buying from the company, you are buying it from a second party, so the company doesn't directly benefit unless your purchase causes the stock price to rise.

(emphasis mine)

This is something I think I don't fully understand -- since post-IPO sales of stocks between third parties don't send any $$ directly to the company, in what ways do they benefit?  Is it just that a higher (or rising) stock price is indicative of faith in the company's profitability/longevity/growth, meaning they can raise capital more easily?

They technically don't benefit beyond the original IPO or PO.  The stock holder is an owner of the company and can have (but usually doesn't exercise) a say in how the business is run.  This can sometimes be a benefit for the holders of said stock and depending on what the shareholder pushed for can be a benefit or future hindrance for the company as well.

There are a few other ways companies are affected by the stock price, here is an overview: https://www.investopedia.com/articles/basics/03/020703.asp

This is an important point (emphasis added):
Quote
Unlike private companies, publicly traded companies are vulnerable to a takeover by another company if they allow their share price to decline substantially. This exposure is a result of the nature of ownership in the company. Private companies are usually managed by the owners themselves, and the shares are closely held. If private owners don't want to sell, the company cannot be taken over. Publicly traded companies, on the other hand, have shares distributed over a large base of owners who can easily sell at any time. To accumulate shares for the purpose of takeover, potential bidders are better able to make offers to shareholders when they are trading at lower prices. For this reason, companies would want their stock price to remain relatively strong to prevent a hostile takeover from another company or individual.

On the other side of the takeover equation, a company with a hot stock has a great advantage when looking to buy other companies. Instead of having to buy with cash, a company will use stock shares to fund the takeover. In strong markets this is extremely common - so much that a strong stock price is a matter of survival in competitive industries.

toganet

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Re: The Index Investing Passive Problem
« Reply #11 on: April 04, 2018, 10:56:24 AM »
If you buy stock, unless it is the IPO or a secondary offering, you aren't buying from the company, you are buying it from a second party, so the company doesn't directly benefit unless your purchase causes the stock price to rise.

(emphasis mine)

This is something I think I don't fully understand -- since post-IPO sales of stocks between third parties don't send any $$ directly to the company, in what ways do they benefit?  Is it just that a higher (or rising) stock price is indicative of faith in the company's profitability/longevity/growth, meaning they can raise capital more easily?

They technically don't benefit beyond the original IPO or PO.  The stock holder is an owner of the company and can have (but usually doesn't exercise) a say in how the business is run.  This can sometimes be a benefit for the holders of said stock and depending on what the shareholder pushed for can be a benefit or future hindrance for the company as well.

There are a few other ways companies are affected by the stock price, here is an overview: https://www.investopedia.com/articles/basics/03/020703.asp

This is an important point (emphasis added):
Quote
Unlike private companies, publicly traded companies are vulnerable to a takeover by another company if they allow their share price to decline substantially. This exposure is a result of the nature of ownership in the company. Private companies are usually managed by the owners themselves, and the shares are closely held. If private owners don't want to sell, the company cannot be taken over. Publicly traded companies, on the other hand, have shares distributed over a large base of owners who can easily sell at any time. To accumulate shares for the purpose of takeover, potential bidders are better able to make offers to shareholders when they are trading at lower prices. For this reason, companies would want their stock price to remain relatively strong to prevent a hostile takeover from another company or individual.

On the other side of the takeover equation, a company with a hot stock has a great advantage when looking to buy other companies. Instead of having to buy with cash, a company will use stock shares to fund the takeover. In strong markets this is extremely common - so much that a strong stock price is a matter of survival in competitive industries.

Thank you this makes a a lot more sense to me now.

Prairie Moustache

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runbikerun

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Re: The Index Investing Passive Problem
« Reply #13 on: April 04, 2018, 03:18:41 PM »
For the first time in my life, I can point someone directly to useful academic writing on the exact real-world topic being discussed:

Appel, I; Gormley, T; and Keim, D, “Passive Investors, Not Passive Owners”, Journal of Financial Economics (Forthcoming), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2475150

If you don't want to read it: the evidence so far indicates that index investors are willing to bang the drum for better corporate governance. In fact, the authors argue that index-fund investors lead to "more independent directors, removal of takeover defenses, and more equal voting rights".

I cannot quite explain how satisfied I am to be able to share this incredibly specific nugget of information. It came up on a risk management module for an academic qualification I'm working towards, and I decided to pull on the exact thread the OP describes to see where it leads. It's by no means a settled situation at this stage, but things look reasonably positive so far.