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.
Anecdotally, I have a few friends who work in the railroad industry and they are currently seeing something close to this. The company is almost entirely owned by large institutional funds.
Union Pacific has a huge drive for constantly increasing efficiency. Their profits are up significantly year over year, but this fall they cut about 500 jobs from their headquarters in Omaha, around 6% of their Nebraska employees, and this isn't even the first time they've done it. To keep the big investors happy they are constantly searching for ways to cut costs.
On the other hand, this might also be a product of the industry. The railroad is necessarily growth constrained. It's unlikely that significantly more products will move to being transported by rail and there is very little room for new lines to be constructed.
I'm not entirely sure your conclusion is correct. Almost 40% of all US freight is moved via rail. The reason passenger trains suck in the US is because our railroads are built for and prioritized for freight. When Berkshire Hathaway purchased BNSF, they noted that trains connect companies between the two coasts of the US. It is often the case that a company that produces something is on one coast but the port where its products go out is literally a continent away. Even domestically bound products have to be shipped between coasts because of how population centers in the US are situated. So assuming the US population and industries continue to grow, I think freight rail will continue to be in demand.
> Believe it or not, sometimes products are unloaded on one coast, transported by rail, then loaded on a ship on the other coast.
That is surprising, since shipping by water is dramatically cheaper than any other form of surface shipping, even factoring the extra distance to sail down to the Panama Canal. What's the point of adding the land leg?
Maybe because the canal is too small? Prior to the opening of the new locks in 2016, the largest container ship that could fit through the Panama Canal was pretty small by modern standards. And even with the new locks opened some ships still have to go around the horn.
Shipping via Panama doubles the distance, and it's probably half the speed as well. Some products will likely benefit from shaving off two or three weeks from China to the EU.
Speed, maybe? I don't know offhand if it's faster or not, but if it is, I can imagine that spending more to get the products to their destination faster could be worth it in some scenarios.
It costs $1,196,397.54 for the largest possible ship to go though.
That's for 13,000 TEUs though (so 6500 standard containers) That's $184 per container. Now think about how much a container holds, and per item for sale it becomes pretty cheap.
My Costa Rican brother-in-law was just telling me that a couple Central American countries are working on new canals because the Panama canal is fairly saturated.
The big index funds aren't exactly known as activist investors. Even if it's "Wall Street" collectively, it's not Vanguard or State Street that is pushing Union Pacific to cut costs.
It's a side effect of having real number feedback on how you're doing. Management can't just make up their own metrics anymore, there is a third party that tells you how well you are doing, and that third party wants to see constant growth or they'll start dropping your price and the financial press will pick up on that and start writing articles about how millennials are killing the rail industry.
It takes real gumption for the upper management to say "screw what the greedy bastards on Wall Street think, we're doing just fine." Especially when their yearly bonuses are tied to what those guys on Wall Street think.
Your comment still assumes active investors who are looking for value stocks. Index funds don't discriminate, they just buy stocks in the entire market.
Index funds don't discriminate against stocks, but they can discriminate against directors and executives who don't deliver their desired profits and returns. Ie, by voting them out. This is already starting to happen. See: https://www.barrons.com/articles/passive-investors-are-the-n...
I mostly read about passive firms voting more on special issues like climate change or good governance. Where did they they talk about voting out directors who didn’t deliver profits? (Honest question, I mostly read the article, then came back to it and hit a paywall.)
> Michelle Edkins, BlackRock’s global head of investment stewardship. “It’s not just about climate. It comes back to the point of governance as a lens, and when it’s not serving shareholder interests, it’s a flag.”
The pressure to increase profits exists regardless of ownership, if anything having large institutional funds own the majority lessens the pressure (vs an activist fund or something similar). If they're leaving money on the table someone is going to take it.
Not really; you can look at BNSF (bought by Buffet) vs Union Pacific. Buffet takes the long view, as a result BNSF has been spending billions on capital projects and hiring.
Wall St is known for encouraging short-term thinking.
I'd say it's a lie that Wall Street is known for short term thinking. Hell, it is even a unofficial motto of Goldman Sachs to "be long-term greedy".
Are there a large number of activist investors who want certain companies to trim fat? Yes. I wouldn't always say that trimming fat is always synonymous with short term thinking. For all the companies that are underinvesting in the future, there are 5 whose management has given them mission creep to invest in areas that incinerate capital. Especially in the current interest rate environment.
BNSF is spending money on capex because it's the smart thing to do in that industry right now. That's not a consequence of a Buffet investment. Buffet also invested in Heinz and they immediately fired thousands and are cutting costs left and right.
You forgot: there's a hard ceiling to how high they can raise prices, because they have to compete with trucks. Together, that all implies that if they want higher earnings, cost cutting is the only way.
Uh... not sure if that's actually the case. Trains are cheaper and actually faster over a long distance. The optimal way to ship is actually intermodal: ship for between countries/continents, trains for long trips over land, and then trucks for the last leg. They don't really compete with each other as much as they work together, especially since they have a standardized protocol for inter-process communication known as containers. Of course electric automated trucks could change all that.
Hijacking trucks filled to the brim with sensors sounds like a recipe for jail time.
The logistics of stopping and looting a truck involves too many parties, and ensuring that each party is following enough security protocols to not be identified via face, vehicle, or gait will ensure that only a few small sophisticated heists will ever be successful.
Anecdata: a fellow driver told me the story of a truck stopped at a light in "a bad part of town." Thieves rushed the back of the trailer, cut the lock and opened the door, just in case there was something worth grabbing.
Another, parked overnight with a load of electronics at the southern boarder. He woke up and discovered the trailer had been broken in to. Yet it didn't seem anything was missing. Maybe something "extra" had been placed on the trailer before it crossed in from Mexico?
In our company we're reminded when we'll travel through high theft areas.
If we're pulling a trailer designated as "high value," wherever we are, we're not allowed to pick it up unless we have the fuel and legal hours to go at least 200 miles before we stop.
My vague point is that every security move in history and to come can be defeated, if it's worth it to someone. And it's always with it, to someone.
[BTW, it "feels" unlikely that a judge or jury would convict based on gait analysis.]
> BTW, it "feels" unlikely that a judge or jury would convict based on gait analysis.
But it does seem plausible that gait analysis could lead to a suspect, who could be convicted (or more likely, plead out) on additional evidence discovered during an investigation.
Has someone actually worked out that tons of sensors will cost far less than people-driven trucks? As it is, fuel is the big cost, followed by driver salary [1]. L5 autonomous driving is not going to come cheap, that gear is going to price as close to 3X driver salary as they can get away with, on the assumption they can run close to around the clock. Whose margin is getting compressed for the additional sensor gear?
This doesn't even touch upon that as soon as L5 is available and if 24x7 L5 operations approved, you suddenly just increased industry transport capacity 3X, leading to a sudden oversupply in certain segments and scenarios, while still requiring a certain baseline to handle peak load demands. That chaos will cause a lot of margin compression, and lots of rosy profit projections from L5 autonomous driving without drivers will turn into a race for finding more customer demand.
I can see some modest sensor gear, but nothing fancy, and not a lot of them. Perhaps high resolution visual and night vision cameras coupled with lots of street camera access, with lots of back-end software processing will deter most theft attempts?
We might ironically get to L5, only to stick lower-paid security guards on a random number of trucks.
The average truck driver earns about $70k a year. Even assuming that the sensor suite costs as much as an entire Tesla Model S(which in addition to a sensor suite includes an actual car), the system will pay itself back in a year.
Also once automated, the trucks can engage in all sorts of hyper-miling shenanigans since they don't have to worry much about traffic during a significant part of their 24/7 operation, especially on more remote roads. That's additional fuel savings.
Sensor packages and near-AI compute clusters constantly get cheaper as the technology improves.
Today it doesn't make sense, but in 10-15 years when a full self-driving solution costs maybe $1k? It's a no brainer, especially for long haul trucking.
I'd guess that putting a security guard on a truck will be an exceptional occurrence, probably only used when the truck is hauling an especially valuable cargo or going through a known trouble spot.
> ...but in 10-15 years when a full self-driving solution costs maybe $1k? It's a no brainer, especially for long haul trucking.
I once spoke with a highly-paid driver (used to be a programmer, using the gigs in truck driving to decompress because our industry generally has worse work-life balance than truck driving...chew on that for a bit) about the US logistics industry.
The driver was in high demand because they consistently tested drug-free, carried various kinds of specialized certs, was always on-schedule or always in communication about problems, and fixed many problems on their own. As I remember the explanation, there is some kind of trucking industry-wide database that contains every driver's trucking records, and it shows every ping of their record to everyone. Might have the details wrong, but the gist was every single time a competing trucking company pinged their record, they got a raise to stay without even asking. So they were in a good position to watch from the best of what the trucking industry could offer. Their contention after observing from inside the industry for a number of years is that the bulk of the US logistics industry is the train companies' to lose.
Placing enough sensors along the tracks and looking outward to the sides of tracks to detect conditions requiring trains to slow down way ahead of time, but otherwise clearing trains to run at much higher speeds than they are allowed to now, would go a long ways to fixing many of the train industry's delivery speed. Upgrade the tracks themselves and the rolling stock to boost the speed even more to match trucking's coast-to-coast delivery time, and there isn't much incentive to use trucks for those corridors rail serves.
Given: (1) sensors necessary to autonomously navigate, (2) large stretches of rural America (out west, maybe 100+ miles to the nearest police station), (3) adaptable human adversay, (4) no humans to injure on the vehicle
... I just don't see how you economically protect a vehicle (vs cargo value).
And more sensors simply mean more things to steal. The minimum law enforcement response time along your entire route is the real issue, and there's no way you decrease that short of drastically increasing police staffing.
These thieves have to steal from a moving vehicle? Sure it's not impossible, but it's more Hollywood heist than something you'd see in real life. It will almost certainly happen a few times, but for practical purposes the amount of stuff stolen before the guys are caught will be less than what it costs to hire tens of thousands of rent-a-cops to sit in the backs of trucks.
Plus, these are thieves we are talking about. Pointing a gun at a human driver and telling them to pull over so they can rob the truck is something that could easily happen today but is extremely rare. The minimum police response time is something that's hard to measure. It might be many minutes 90% of the time, but if you do 10 or 20 of these heists eventually you're going to get unlucky and the cop will happen to be sitting at a speed trap right there are you're busting into the truck.
This is the fundamental problem with crime. You will get away with it most of the time, but when you don't you're fucked. It's a lousy career choice because the upsides are modest relatively speaking, and the downsides are huge. If you're going to be a criminal the trick is to steal enough to retire on and then immediately retire. Knocking over one random truck is not going to do it.
You can get a 50 BMG rifle for a few thousand dollars and put a hole right through an engine block.
Unload truck at your leisure.
That's not even getting into ways to make an automated system stop by putting up an emergency / stop sign in the middle of the road.
The risk to stealing is directly proportional to the chance of getting caught, which broadly correlates into something unexpected happening, which is drastically diminished by not having a human driver.
> You can get a 50 BMG rifle for a few thousand dollars and put a hole right through an engine block.
So, how does a single, or even a 2 driver truck prevent this TODAY? The only reason I can think is conspiracy felony murder of 1 or 2 people w/ clubs, guns, cell phones has a higher risk than conspiracy felony larceny?
You've concocted a great hollywood heist scene; but if you're Fast and the Furious driving through South America, it's The Rock and the Swat team hanging out in cargo hold you have to worry about; not whether the truck has an autonomous driver or not.
> So, how does a single, or even a 2 driver truck prevent this TODAY
See my last paragraph.
Defending an unmanned vehicle is the walls vs guards argument: it's far harder to build an impassible, unguarded wall than it is to build a difficult, guarded one.
> Defending an unmanned vehicle is the walls vs guards argument: it's far harder to build an impassible, unguarded wall than it is to build a difficult, guarded one.
When it comes to shooting out an engine block, you're already past difficult. If you're blasting the doors, you're already past difficult.
But most of all, a truck driver is not a guard. Very few guards are guards of things that are insured. Driver, staff, and security guards (even banks) instructions typically include "protect yourself, but if something comes between your safety and the load safety, choose your safety".
To keep up with the Fast and the Furious movie relation; the first movie was about the FBI trying to prevent robberies BEFORE truck drivers took action after the FBI had instructed the truck drivers to not be heros.
>>> So, how does a single, or even a 2 driver truck prevent this TODAY
>> See my last paragraph.
> The risk to stealing is directly proportional to the chance of getting caught, which broadly correlates into something unexpected happening, which is drastically diminished by not having a human driver.
You're missing the forest for the trees. A human witness is a deterrent because our court system says they are.
"Sir / Madame, could you pick the person you believe robbed your vehicle out of this lineup?"
Shooting out the engine of a vehicle traveling at a constant 55-85 mph down a straight interstate is a turkey shoot if you have the proper caliber.
I thought this was HN? The technical and creative requirements for this theft barely rise to "a bored Tuesday at the dorms."
This assumes the truck has no way to call for help when something goes wrong, or that people driving on the same road won't call the cops on you. Long haul trucking doesn't usually happen on deserted backroads.
I'm just saying that the worry about theft is probably overblown. It's almost certainly going to be rare enough that a regular insurance policy will be sufficient protection. People can be hired for exceptional cargo, but that's true today too.
Have you ever driven interstate east of the Rockies and west of the Mississippi?
If not, you'd be surprised how bare it is. Especially if automation kills the truck stops.
We'll see. The means are trivial for any enterprising farmer, and I think the moral calculus drastically changes once you remove risk to a human driver from the equation.
There are multiple mile long trains with only 2 people on board at any given time, unmanned trucks won't be a problem as they'd likely travel just travel convoys with a couple people overlooking the fleet.
They do if you are automating them to avoid having to pay human drivers. It's kind of silly to go to all of the effort to automate a truck and then make someone sit on their thumbs behind the wheel for hours on end.
If you can reduce legal risk(accidents) by 50x or 100x and extend the road time by 2x or 3x, then paying a security person seems like a doable call. Especially if you can pass some of that premium risk mitigation on to the customer, if load value dictates.
Raw hourly cost may not even be the primary point under the manpower line of reasoning. It is certainly important, but not necessarily the key issue.
You can't increase road time with a human driver at the wheel, that's a safety issue.
While it's already dubious to hire a driver for an autonomous truck, it's even sillier to pretend that the driver is useful when you're having the truck do the work while the driver sleeps. Extending road time by 3x means running the truck 24 hours a day, and keeping a person awake that long will not improve safety.
But why? I would think that trains, which aren’t constrained to gasoline and have dedicated tracks, should be able to obtain higher efficiencies compared to trucks going the same long distances?
Think of shipping as an optimization problem where various modes are selected for different parts of the path. You have to run the optimization problem to see what mix makes the most sense -- and don't expect it to necessarily be simple or obvious.
Logistics is complex; you'll also need to factor many things into the optimization:
* both fixed and marginal costs of each mode (e.g. maintaining track, monitoring safety, wear and tear on vehicles, varying fuel costs)
* constraints (due to technology, personnel, regulations, etc)
* fluctuations in demand and shipping objectives
* lots more
If you want to focus on only one slice of the problem... Sure, for the exact same route (meaning that a particular track has already been built), one would expect that trains are more efficient. The data shows that; e.g. https://en.wikipedia.org/wiki/Energy_efficiency_in_transport...
you are correct. That's why they don't really compete with each other. You put it on a train for a long distance and then trucks pick it up to spread it out from there.
Sometimes people use "compete" in a casual way that overlooks key economic connections. Competition is a force that is always present, even if it is not currently the "most obvious" factor in play at a given time.
I think any definition of competition must be relative to the sphere of economic activity. So, when it comes to transportation in general, rail and trucks do compete -- by this I mean they offer services with varying prices and characteristics.
Just because rail and trucking have different sweet spots at a particular point in time does not mean that they don't compete. Both (a) think about how and why customers choose them over the other, (b) seek opportunities (for investment or growth) that lead to a competitive edge, and (c) therefore, influence each other.
that's what my "really" was meant to convey... "they don't compete with each other" would be contra what you said, "they don't really compete with each other" isn't. A different way of saying it is "Trucking is not competitive with trains at certain distances"
He is mentioned here pretty regularly, so many may already be aware, but Matt Levine discusses this and its variants a lot in his newsletter, most of the time under the heading "Should index funds be illegal?"
Index-funds also have a huge risk: as they become too large, they become distorting how pricing of companies work: i.e. just IPO'ing gets you purchasers.
At some point, the phrase "passive management > active management" will become verifiably false.
This. I haven't heard anybody talking about this before, but it seems like there's an unavoidable tipping point here. I wonder if we've already reached it. Rightly or wrongly I trust my stock picking over an index fund now. At least I can take responsibility for the outcome.
I think just as the market will find a balance between passive/active, individual investors will most likely also find benefit in doing part passive part active.
Why would that matter? If they are obligated by their funds' charters not to intervene, then all the governance decisions happen exactly as if they hadn't invested, right? 10% vs 90% of share votes being on auto-pilot shouldn't matter?
Is the argument that the vast majority of them could change their funds' charter to allow them to be actively involved with governance? If so, that would be really hard to achieve even if many of them worked at it.
Edit: three people have made the same "it's easier to get a controlling interest" argument. See my reply in the follow-up before making another redundant comment.
> 10% vs 90% of share votes being on auto-pilot shouldn't matter?
I'm not familiar with these non-intervention clauses, but in the 10/90 scenario haven't you made it much easier to seize control of the company? Now I only need 5%+1 of the shares to do as I wish?
If 90% of shares are non-intervening that means hostile takeovers are now 10x cheaper to implement. It would be weird to be a company with market cap $100M, where $10M could buy a controlling interest in voting shares.
That seems like a different kind of problem though. If funds that vote according to the recommendations of the board own >50% of the company, the board becomes unaccountable. (Unless they apply different rules to board elections, but then we're back to the original problem because the minority activist can elect their own board.)
This seems to be mostly in keeping with the spirit of index funds. It's a hands off approach that lets the company run itself.
In theory an index fund should never own that much of a company, because that means it would own >50% of all publicly traded companies. The whole point is to spread the risk evenly so you can realize the average returns without having to put any thought into it. It shouldn't mean it's buying $100k shares of GE and also $100k shares of Mom&Pop Pickle Fork Inc.
But if all the index funds together own >50%, and they all go with the board, then it's the same as if it was a single company that went with the board.
> If 90% of shares are non-intervening that means hostile takeovers are now 10x cheaper to implement.
Naively (ignoring other dynamics of index funds), sure, compared to 100% investors actively engaged in governance. But I suspect investment in index funds replaces largely hands-off direct investment and so, market wide, has virtually no average effect on that (though it may shift the effect among firms compared to those investors doing so directly.)
It's not any easier (to a first approximation), because the share price will increase as you try to buy in, and the lower fraction of actively traded shares makes them that much more scarce and ramp up in value that much more quickly.
To expound what you're suggesting, which is completely ridiculous, is that if someone buys 5.1% of actively traded float, the price will exponentially surge such that it would be equivalently priced to purchasing 51% of float in a market without a 90% passive stake.
Not only that, it doesn't account for short sellers. Index funds will happily lend their "passive" shares to anyone (i.e. short sellers) willing to pay interest. So if prices start to rise as someone tries to buy 5%+1 of the shares, others will rightly determine that the shares are now overvalued and start selling them short (especially if the buyer is expected to harm the company), allowing the buyer to keep buying at a minor premium over the original price. Or even at a discount, if the purchase is seen as inevitable and the damage they're expected to do gets priced in.
> then all the governance decisions happen exactly as if they hadn't invested, right? 10% vs 90% of share votes being on auto-pilot shouldn't matter?
If that was the case it would have been easy. Handful of people fighting for power.
But from what I can read the problem is exactly the opposite. As someone said below that Blackrock has been known to rubber stamp executive salary and maybe others follow suit. What is then stopping companies from going bigger and bigger on executive salary knowing that they will get rubber stamped from the funds?
What happens if there is a complex governance issue which requires vote and the index fund lack the motivation to ensure that they have weighed all the decisions correctly?
Ignoring the obvious controlling interest issues which others have mentioned, which is the largest issue...
That's a funny contradiction of a sort - then the index fund becomes the agent it's supposed to be observing.
For one, Blackrock is not Berkshire Hathaway - and in reality, obviously Blackrock can't wake up tomorrow and decide to be. They're not built for that.
Another scary thing is that the market is being increasingly turned into a derivative, and the underlying asset becomes more volatile (certainly for many different reasons) as it becomes proportionally smaller .
Bogle has gone on record that he believes the market efficiency limits of passive indexing are somewhere in the 70-90% range of equities held inside such broad market indexes [1]. A more reasonable and less click-baity headline would have been "Bogle Sounds Governance Warning on Index Funds".
Blackrock have a history of rubber-stamping executive pay packages. In the past, they've voted in favour of proposed CEO pay packages in something like 99% of cases. Some people have argued that doing so benefits Blackrock execs themselves because high pay then becomes the norm.
A lot of them outsource voting decisions to companies which exist just to aggregate the most "corporate/sensible" way to vote. So the parent saying "they're not activist investors" is probably true, but then every single vote proceeding along "maximise profit according to a consensus view" lines probably isn't great for society.
I have a hard time seeing it as unintended. If you are not promising any differentiation between yourself and the index than the only thing to really compete on is cost. There are economies of scale in finance, specifically if you need to optimize solely for AUM.
There's definitely a race to the bottom going on with the free Fidelity funds and Vanguard reducing the dollar minimum by 70% for a lot of admiral shares.
Because eventually businesses wake up to the fact that they need to make money. And they do it by going the absurd route.
For example, online help is free but if you need to talk to a human being support, give us $10 a call or something. And while an average consumer might not be affected, people who are actually affected end up a nightmarish situation.
Yeah, it's not surprise that corporate governance is at its worse state in decades. Too many companies have boards filled with management sycophants who never due real work in guiding corporations in the interests of shareholders.
> but that their popularity is leading toward a handful of financial institutions holding controlling interests in most of the largest companies.
Which allows for them to do things like demand publicly traded recruit women to their boards. Which is a useful talent when you are focused on economic growth, and your holdings are focused on extreme paper-meritocracy that fails to result in actually addressing additional portions of a market because their talent pool can't perceive it.
Right, because when shadowy groups get unimaginable leverage and power the first thing they do is apply affirmative action pressure to address gender imbalances.
> Right, because when shadowy groups get unimaginable leverage and power the first thing they do is apply affirmative action pressure to address gender imbalances.
State Street also used that as a marketing stunt to launch an ETF while they were being sued for sexual harassment and pay discrepancies between male and female employees. Marketing is marketing is marketing.
Nothing exists in a vacuum just like solely attributing companies adding female directors to a marketing stunt. There was large momentum on this front already that would have happened with or without this.
I never meant to imply positive things couldn’t happen, just that it’s silly to assume one very specific positive thing is the most likely thing to happen.
> A bit click-baity, but the warning here from the father-of-index-funds is not that they've become a bad investment
I really doubt that he will ever come out and clearly say that they've become a bad investment.
But the insinuation is that going forward index funds might cause harm to public's interest. And law makers need to come up with laws to ensure that doesn't happen.
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.
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.
Even without index funds the drive towards large portfolios and diversification would do the same thing. I'd go so far as to say that unified ownership of competing firms by large investors is just unhealthy in general. Not really sure what can be done about it though since many companies are rather multi-industry.
Well the idea of an index, whether done through a fund or not, is to buy some of each company. A value investing approach would be to find the better stock and invest in it, so Coke stockholders would rarely own Pepsi stock and vice versa.
Still, even without index funds, the first thing most people are told is that diversification is key and that sector allocation matters more than the specific companies you hold. Plus people want to mitigate risk, so they buy a little of each thing that matches whatever profile, and soon a sector essentially has unified ownership interests rather than competitive (and antagonistic) ownership interests.
If Coke could take an action that would make them $1 million but cost Pepsi $1 billion, why wouldn't the two companies come to an agreement for Pepsi to pay Coke a one time sum of X where X is between $1m and $1b for Coke to not do it? A single entity owning both corporations should not be necessary for the efficient outcome to occur in this hypothetical.
These are not negotiated activities operating in an environment of collusion. They are the result of separate corporations operating in an environment assumed to be competitive. Individual corporations will take strategic actions that may harm their competitors disproportionately to the benefit they receive. It is not zero-sum, and would be economically value-destructive for shareholders of both (while possibly beneficial for consumers).
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.
They could even just hold their own internal vote immediately before the actual vote and net out the results. Then vote this result in the actual vote. I don't think there is a rule that if you vote, you must vote with every share.
Also gets rid of any issues of fractional voting; they can track fractional votes in the internal vote, and then just round the result in the actual vote.
The biggest problem is that generally index funds try to take a pretty passive approach to management decisions (although they do vote in some circumstances). If the index funds allow their investors to vote on everything, to some extent they stop being an index fund that passively tracks the market.
> If the index funds allow their investors to vote on everything, to some extent they stop being an index fund that passively tracks the market.
That doesn't really follow. Tracking the index and voting are two separate concerns.
That's part of the point of Bogle's objections (I think - I can't read the article, I can only read about it), that they're involved in management already, even though that's not part of their mission. Simply voting based on a proxy vote of the fund's shareholders is arguably more "passive" for the fund management than what they're doing now, if you're concerned about passiveness.
> Tracking the index and voting are two separate concerns
I do not believe this is really true. The entire point of exercising shareholder rights by voting is to improve the performance of the company. A shareholder's decisions might be right (improved stock value) or wrong (reduced stock value), but you can't argue that it's passive involvement in the company. Changes in a company's stock price will necessarily cause changes in the index that the index fund tracks.
Now, let's consider the point of an index fund with a passive investment strategy: the goal is to remove the need to make decisions in how a company operates and leave that to the better-informed investors and marketplace as a whole. Index funds in the ideal world simply want to ride along with what decisions the marketplace is making in the companies that the index tracks.
This is an important tension that really cannot be resolved if index funds are to be considered passive and also vote.
In practice, the votes made my index funds tend to be (thus far) ones that are on less controversial issues like best practices for management, etc. You don't see Vanguard pushing for mergers or spinoffs like Carl Icahn would try to do. However, in principle all shareholder votes exist on some continuum of activist investing.
I don't see you disagreeing that the hypothetical voting shares via proxy is essentially more "passive" than the decision making they're doing now. I believe what you're saying is that they simply shouldn't vote at all.
I guess that's basically the most "passive" option, but it would have some weird results. I believe - and I'm well informed but not an expert when it comes to this - we'd find that at a lot of companies, if you take away the large institutional investors, the portion that remains includes a large number of activist shareholders of various stripes. Those activists would necessarily be strengthened in some ways by the majority of shareholders sitting out every vote.
There's an utterly pretentious Rush lyric that comes to mind, about choosing not to decide still being a choice, or something.
edit: I see that Bogle kind of hit the same point:
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.
Nothing stopping that, and they do that to some degree (I get emails from Vanguard once a quarter or so asking me to submit my proxy votes). But realistically, through my Vanguard funds I own very small pieces of thousands of companies around the world. It is in no way worth my time to try to make an informed decision on the shareholder votes for all of those.
The article says that this solution has unintended consequences too, since you are now transferring voting rights from the share owner, who cares about the long term performance of the company, to share renters, who generally just care about the short term, which is counterproductive.
Although I'm not sure I get that - I don't quite see how the renter's would be especially more short sighted - it's not like the fund is obligated to hold the stocks any longer than anyone else.
> you are now transferring voting rights from the share owner, who cares about the long term performance of the company, to share renters, who generally just care about the short term, which is counterproductive.
This logic is backwards; index fund holders are more likely to hold their shares for a longer period of time, compared to day traders. The whole point of index fund investing is to avoid short holds.
Also, what percentage of index fund investors hold those shares only in the short term? I thought much of the point of index fund investing is that it's great for a relatively low-effort, reasonably-diversified buy-and-hold strategy on the part of anyone from individual investors planning for retirement to institutional investors managing pensions?
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.
If I'm wrong, can you explain what I'm wrong about?
The risk is that Vanguard, State Street, and Blackrock, employ small 'governance teams' whose job is to vote on your behalf. Since they don't have an explicit fiduciary duty to the shareholders of the index funds, but do have an implicit one, it can be argued that you don't actually have a vote in how the component companies are run. More here: https://outline.com/njXPEu
You do not get 3,641 letters asking you to vote in each of the companies that make up VTI. If you own shares of a company directly you will get a letter and you may get a letter about governance of the fund you own, but not for the individual names in it (you own a piece of something that owns the actual shares).
the issue arises because typically the fund acts as your proxy when it comes to voting rights (most index investors are looking for a reliable and easy return, not a voice in corporate governance).
No it is not. It is 100% false with respect to voting rights.
The most visible sign of Vanguard’s engaged ownership is our funds’ proxy voting at shareholder meetings. We have an experienced group of analysts on our Investment Stewardship team that evaluates proposals and casts our funds’ votes in accordance with our voting guidelines.
Fund holders do not vote on corporate issues of stocks held by vanguard.
And of course, the owner of stocks held by a mutual fund are the mutual fund. Is that not clear to most people?
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.
...
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.
> "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."
Of the proposed solutions, some combination of the following three items would be a solid first step (incremental without being too drastic):
* Full public disclosure by index funds of their voting policies and public documentation of each engagement with corporate managers.
* Require index funds to retain an independent supervisory board with full responsibility for all decisions regarding corporate governance.
* 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.
> 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.
That's easy to say, but deciding what the shareholders interest is can be incredibly difficult. On any difficult decision, like "should this merger be approved", index funds taking any position is the same as active management.
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.
Does anyone know of any investment risk to index funds if everyone is now doing it?
The risk is because index funds don't do stock analysis (instead they buy and hold all stocks) they will invest in bad companies and prop their price up. Then when the bad company goes bankrupt (as everyone paying attention knows will happen) the index funds are left holding all the stock suddenly worth nothing.
Which is to say the traditional more expensive managed funds that actually pay attention to the fundamentals of the companies they invest in should see a comeback. While this style of fund is more expensive (because a human can only examine a few companies in a year in enough detail to decide if they are worth investing in - as a full time job you can maybe do 50) by investing only in companies that will do better than average they can beat the market (or shorting if you want to play companies that will do far worse than average). So far the low costs of index funds have made them a better investment despite them not investing in strong companies, but we should see the day where a managed fund can beat the index funds just because the index funds are leaving the advantages of analysis on the table.
You can argue [meaning this might or might not be correct] that historically managed funds have done worse than index funds because there are so many managers that anytime there is a slight deal someone jumps on it before the deal is large enough to pay for the costs of finding it. However if you don't jump on it someone else will and they make something on the deal while you make nothing. Thus as index funds take over there will be more and more deals for the managers to find, and managers can wait until they are large enough to be worth the price.
It will be interesting to see when/where the line is crossed.
I think this is almost true. It would be true if index funds held all the stock. But since they don't and managed funds still exist, the stock price will go down when managed funds decide to sell. When the stock price goes down, the shares become a lower fraction of the index, so the index funds will also sell some.
I think the main point is that index funds still rely on traditional market players to effectively allocate risk. And as index funds take up more of the market, they become less able to do that. Right?
The index fund doesn't need to take any action to respond to price movement. When the stock price goes down, the shares become a lower fraction of the index and also a lower fraction of the fund's holdings.
The fund has to manage holdings around fund purchases and redemptions, and when the index changes.
This is not exactly true. Many (most?) indices are market cap weighted, so if a company’s stock is tanking (i.e, their market cap proportional to other tickers in the index is going down), the index will sell the shares.
In my view, index funds aren’t really passive at all, they are crowdsourcing the best ideas of active management. This is why many indices (like S&P 500) produce pretty good returns.
If you created an index held every US equity in equal proportions, regardless of price movement, that would be like what you’re talking.
If you compared the returns of the S&P 500 against this theoretical index (let’s make it an ETF and call it “DUMB”), you would find that the S&P 500 would have much better returns.
The takeaway from this is that many indices produce stellar returns and aren’t as “passive” as one might think. Think of factor indices or whatever.
The point is that the stock won't always tank when they're doing something that'll negatively affect fundamentals, because too few people are actively researching & investing in the stock to affect the price. And then when a tipping point is reached and the stock price starts to go down, index funds will exacerbate the slide as they rebalance out of the falling stock and sell off its shares.
Normally markets remain efficient because they provide an incentive for people to actively research & surface all available information on a company's future prospects. If most people aren't doing this, then a.) the market price will be slower to react to bad information about the company and b.) people who do actively react will make larger profits, as they can trade on their information before the majority of the market takes it into account.
There's an equilibrium level of disequilibrium - as more people pursue passive investing, returns to active investors rise, until some of those passive investors realize they can make large profits as active investors, restore market efficiency, and destroy the profit potential of active investing. I'm not sure exactly where we are in that cycle, but there's some evidence that stock prices have become less volatile overall except for major news-related panics, which would be expected if a large proportion of people are passively investing.
The caveat is that doing active management can get expensive in a hurry, which is why traditional funds tend to underperform index funds. It's cheaper to have some simple rules that a computer can execute and occasionally eat losses than it is to hire a bunch of experts to do tons of work to avoid those losses and end up costing more than you would have lost.
Ultimately the problem domain of monitoring every publicly traded company and prognosticating their actions is huge, and the job is so messy that it will never be cheap. There should be an information theory paper on this somewhere.
Index fund investors are classified as "passive investors," while others are "active investors."
The main investment risk to index funds growing is that, if everybody is a passive investor, then the passive investors are worse off as there are very few active investors who actually try and value companies appropriately.
On the other hand, if the market is littered with active investors, then the market is likely more efficient and 'correct', and so you're (probably) better off as a passive investor.
As an "active investor" your competition is HFT algos on servers located as physically close as possible to the stock market in order to achieve superhuman reflexes. Which you have absolutely zero hope of beating.
I'd rather see slower, predictable gains than bet my nest egg trying to go toe-to-toe with hyperefficient machines -- or hand it off to some Manhattan finance bro making that bet on my behalf.
I'm going to upvote your comment because I don't think it deserves to be downvoted, and at the time of writing it's grayed out for me.
That being said - you're incorrect about about competition between active investors and HFT. That's a common misconception. HFT primarily occupies a marketing making role, which means they try to play both sides of the spread very quickly for a very, very small profit on each trade. There are elements of valuation here, but what's really much more important is very small holding times and low latency turnaround. The ideal goal of an HFT operation is a trading strategy which earns a profit 51% of the time and trades very frequently.
In contrast, active investors - whether quantitative, fundamental or some mix thereof - care more about being correct on fewer bets, which have more money behind them and which are held for longer periods of time (hours, days, weeks or months). These funds are not competing with HFT: HFT only competes with HFT. This is because HFT activity and active investing activity are completely alien to one another. HFT has a material impact on the profit margins (slippage), volume and liquidity available to active investors, but strictly speaking they don't actually compete (except in the narrow sense that you "compete" with a car salesman to buy a car for a better price).
HFT is a relatively tiny portion of the financial industry which gets outsized attention. It's generally more accurate to think of HFT firms as financial utility providers rather than investing firms.
HFT is basically a tax on each transaction that gets applied because you don't have as accurate a view of the market as the guy who is down on the wire. If you're strategically buying shares in a company and holding them then HFT is not your competitor.
If you're a day trader trying to flip stocks by holding them for a couple of seconds at a time HFT is why you're bankrupt.
But it's also not true that HFT folks create markets. To create a market you need to sit on shares and offer them for sale. HFT leeches off of existing markets. It's true they offer share for sale, but only ones they bought a few nanoseconds earlier for the original price.
Day traders flipping stocks every few seconds won't lose money because of HFT firms, they'll lose money because of trading fees. Trading every few seconds is a wildly unrealistic strategy for most people to pursue on their own. On an average, per-trade basis the fees associated with buying and selling are several orders of magnitude higher than the profit margins of any HFT strategy. The only way your fees will even come close to the profit margins of an HFT are if your volume is such that you've become a market maker yourself. This is a very basic and fundamental tension that precludes HFT from being a competitive force to other traders engaging in speculation and investing.
Your final paragraph strikes me as ideologically bent, particularly with your use of the word "leech." It's an uncontroversial fact that HFT firms facilitate market making. HFT firms do sit on shares and offer them for sale. Most often they do this quickly, but occasionally they have holding times with longer horizons. What's more important than the turnaround time is the low latency with which they execute orders. Definitionally, HFT is engaging in market making because when someone wants to purchase a share, an HFT is ready to sell it to them. Likewise when someone wants to sell a share, an HFT is ready to buy it from them. This is quite literally, "making a market."
In point of fact, your hypothetical day trader would not be capable of buying shares every few seconds if it weren't for HFT (inadvisable though it may be). How do you propose they'd achieve the same kind of liquidity otherwise? By calling a broker? There are far fewer market makers than there are active investors. Passive investing activity with index funds also dwarfs the scale of HFTs. The straightforward conclusion that follows is that fewer, faster parties must exist to make markets for the many, comparatively slower investors.
This is an extremely well-studied subject; when you peel back the pomp and PR about HFT as an industry, you'll encounter an incontrovertible reality. There is no way to service modern trading activity happening every second without the HFT activity that happens every microsecond. By calling that latter activity "leeching", you read more like someone delivering an opinion rather than a cogent, well-informed and substantive criticism.
At the end of the day how much position does a HFT firm hold? If nothing has gone wrong it is zero.
Just because they're stuck holding the bag on trades that end up being cancelled sometimes and have to wait for them to unload doesn't means they're making markets. If a market doesn't already exist the HFT firm is not going to create it.
They absolutely do increase the volume figures on markets, and that can be interpreted as making markets, but it's not an accurate representation of the big picture.
> At the end of the day how much position does a HFT firm hold? If nothing has gone wrong it is zero.
This is also incorrect. HFT firms routinely hold positions for days and weeks. It would be inefficient and strange to literally deplete all positions and begin fresh anew each day. Executing orders with extremely low latency is not equivalent to be perfectly symmetric in buy and sell orders.
I encourage you to learn more about the topic you're talking about, because what you're saying is substantially at odds with how the industry actually works. At this point I'm curious how you would define market making, because it's very ironic for me (and anyone else reading) to hear you say these things and talk about what is or is not "an accurate representation of the big picture."
That's why being a passive investor is often the best route for the average person, unless you have the opportunity to invest in a successful fund that takes an active role, or you put in the effort (and have the skill/luck/whatever) to invest yourself.
I'd point out, however, that your competition is usually not "HFT algos on servers located as physically close as possible," unless you are, yourself, a HFT trader. Even if you're buying a security for a few cents more because an HFT firm has corrected the price, if you're holding for weeks, months, or years... what's the difference? There's room for both of you to succeed, as long as your investment philosophies and holding periods differ that significantly.
Stock pickers managing active mutual funds aren't competing with high-frequency traders at all. The human stock pickers are buying with the intent to hold for at least several days (usually even longer).
If you want slow, predictable gains then invest in highly rated bonds. Handing investment decisions off to some Manhattan finance bro is unlikely to improve your long-term risk-adjusted returns.
There are active investing strategies besides HFT. One example is Buffett-style value investing, where he picks a few good businesses with large moats and great cash flow and then holds them for decades. This is about the polar opposite of HFT (where you hold for seconds and don't care about the underlying business at all), but both fall under the general category of active investing.
> As an "active investor" your competition is HFT algos on servers located as physically close as possible to the stock market in order to achieve superhuman reflexes.
That's usually not true at all. HFT makes up a huge portion of market volume, but for almost all investors is basically negligible to their return, despite what Michael Lewis might scare you into believing. HFT firms make a comparatively small profit in the universe of Wall Street, so they aren't eating your returns.
That's not to say actively managing your money is not difficult. You're mostly competing against sophisticated investors and firms with a far greater capital and knowledge base than you. It's just that in general, the majority of capital being bet against you is not from High Frequency Trading
I'd say this article probably overstates risks. US Equities are only about 30% passive, depending on how you measure it, and there probably is substantial run-rate for an even greater concentration.
one risk is that if too many people are invested in index funds (passive, not buying or selling based on new information), then the price of those stocks is determined by a small group of active investors
So long as the pool is large enough that doesn't matter. Index funds just need the price to be close to reasonable to work out. When the price is not reasonable index funds do well. In general active investors work to push the price to reasonable levels.
Of course there is such a thing as price manipulation which active investors can try - if there are only a few and they work together this can work out. However the investors have incentive to cheat when working together as the cheater wins against his peers, thus this currently is confined to "penny stocks" (for example the company behind the stock doesn't exist anymore but they didn't properly delist their stock so technically it can be traded - you can buy such stocks for say a penny each and then hype them to suckers as the next big thing and sell for 10 cents each and make a killing - since the company doesn't exist no one else pays attention and the scam works.)
A risk is one of the options, which is a breakup of existing funds: "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."
So long as the two broken up funds are both index funds it won't matter. Index funds all work the same way so a million tiny funds will have the same effect as one large one.
Theoretically, yeah, but like a lot of tech companies, index funds are a high-ish fixed cost and low marginal cost business. The staff/IT/compliance/etc. costs to run a fund don't scale linearly with invested assets so functionally a million tiny funds would be much more expensive to operate (collectively) than one big one. You'd have to have somebody at each fund voting in all those shareholder votes, right?
I believe breakups would drive up the expense ratio which is why Bogle said that it would be damaging to individual investors. Part of the reason why Vanguard is so cheap to operate is because of its size contributing to economies of scale. You can see small variations in the expense ratios now (for example Fidelity is slightly higher cost than Vanguard across most apples to apples comparison funds) for this reason.
I don't consider myself very savvy in investing, but I guess if "half of all stocks" are owned by index funds that's a concentration of ownership that might be considered unnatural at best.
I didn't read past the paywall but one good thing if more and more people own index funds then they are participating in the success of those corporations represented in that index. Might tend to tone down some of the shrill agitation that everything "corporations" do is evil and greedy.
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??
i thought an index fund's health depends on the health of the companies inside it. even if people decided they wanted to replace their index funds with direct stock purchases they managed themselves, the underlying value of the fund wouldn't change right?
> 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.
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 managers 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.
Exactly. Once an index fund is making active decisions about the management of a company, it's no longer a passive investment vehicle (though they never really are in the first place, given indexes like the S&P 500 are decided by a committee).
> The index fund managers 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.
As long as there are at least some active investors left they can, because they follow price changes set by active investors passively.
If index funds start to create systematic valuation errors, active strategies start to perform better and they start to outperform index funds. This is not the case, because index funds beat active fund management constantly over longer periods. (The article raises concerns of corporate governance and accumulation of power that is different issue).
>there is an alternative view that the rise of passive investing will improve capital allocation, because bad active investors will be driven out but good ones will remain. The passive investors can't influence relative prices, since they just buy the market portfolio, meaning that the fewer but better active investors will continue to make the capital allocation decisions. On this view, lower returns to active management are a sign that prices are more efficient and capital allocation is getting better
>index funds beat active fund management constantly over longer periods
This was only the case because 'long periods' include the periods in which free riders (indexes) were small relative to the active and activist shareholders.
When was the last time they did that anyway? Or tried? For a while, Wall Street has been more interested in predictability or volatility than in actual risk. They flat-out don't care whether an investment will tank, so long as they can predict (or sometimes even control) the timing. Or use some minute technological advantage to reap the rewards before someone else does. The very nature of hedge funds is to be good at measuring potential arbitrage rewards, not actual risk. Copycat behavior only exacerbates a problem that already existed.
Sure, as long as there are some individuals or firms who are not invested into index funds. Theoretically they might even prefer this situation, since if they can accurately price equity risk they will make more money if everyone else is wrong.
The real question is, what is the minimum number of active investors required for accurate pricing of risk in a market dominated by index funds? I'm not aware of an answer that is widely accepted as clearly right.
In theory it might only be one! If there's only one active investor, and they find stocks that the index funds have not priced correctly, then the active investor can pounce, make some money, and move the stock toward a more accurate price. The more they do this, the more money they will make, and the more resources they will have for finding and taking advantage of mis-priced stocks.
The real trick is telling what an "accurate" price is, so that you can evaluate whether the market is working properly. Since the purpose of the market is to find the accurate price, asking whether the price it finds is accurate seems like begging the question.
Is the stock market pricing risk accurately now? Was it pricing risk more accurately 40 years ago, before the growth of index funds? There have been plenty of bull and bear markets during that time... and some nasty unexpected shocks.
There are more stocks than an active investor can research the fair value of. If we are talking about a single stock, one active investor with enough money can force the "correct" price.
(Index) funds solve a problem that we shouldn't really have anymore.
The problem is that (semi) manually trading securities is inherently expensive.
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.
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.
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.
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?
What about the problem that retail investors necessarily don't have good insights about individual companies (or stock pickers) but still want to benefit from economic growth?
You would have to trade constantly. Moreover, most people probably don’t have the capital. You can’t buy a fraction of a stock, and since the S&P is market cap weighted you would need a lot of stock in order to do anything like the S&P 500
Really, you don't. If you want to track a market cap weighted index, you only need to trade when the index composition changes, which isn't that often.
But also, that's not exactly something that couldn't be automated, is it? That could be a service offered by banks: automatically keeping your portfolio matched to a particular index.
The point isn't that you should be doing the work of a fund yourself, the point is that you should directly own the stocks. For one because that means you have the voting rights, but also because that would make you less dependent on any particular company. If you are invested in some company's S&P500 ETF, the only way to switch to a different company managing your S&P500 investment is by selling the old one and buying the new one, which causes transaction costs and can have massive tax consequences. If it was just your bank managing the stocks held by you, you could just transfer them to a different bank and have them take over the management.
(And also, it would allow minimally "active" investing even within a passive framework: If your bank is managing your portfolio for you, it would be much easier to, say, exclude a particular stock. It would technically be trivial to implement "S&P500, but without Facebook", say.)
> Moreover, most people probably don’t have the capital. You can’t buy a fraction of a stock, and since the S&P is market cap weighted you would need a lot of stock in order to do anything like the S&P 500
That is one of those things that I meant by "practical problems". If you think about it, that isn't really a fundamental problem. There is no fundamental reason why stock ownership has to be organized as "shares" that represent a fixed, relatively large, share of the company. We could in principle move to a model where you can hold more or less arbitrarily small pieces of a company, including arbitrarily small pieces of voting rights. Why shouldn't it be possible to just buy 0.00000000687 pieces of Berkshire Hathaway A for a cent or so, to have legal ownership of that piece, and to have the voting rights for that piece? None of that is exactly difficult to do with computers.
There were practical reasons why doing things the way we do them made sense, back when shares were physical pieces of paper that you moved around physically. But it really doesn't make a whole lot of sense anymore given our current technology.
> Tracking the index on your own would be more than a full time job. You could do it automatically, but that just reinvents the fund
That reinvents funds ... without the problem of accumulating all the power in a few hands, which was exactly my point?
> The S&P500 had 500 stocks. Do you want to vote ~1.5 times a day?
No, and why would I have to? For one, many index funds don't vote on many stocks either. But more importantly, the point is to unbundle voting rights from the portfolio management aspect. Just as that doesn't mean that you have to manually track an index, it doesn't mean you have to manually vote either, does it? You can just delegate it to some group that you think represents your interests, and you could do so selectively. If some group wants to get some particular company to change something and you support that, you could just delegate the voting rights for that one company to that group.
> 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.
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.
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.
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.
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.
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.
Have you ever voted before? Assume 10 questions per company. Exposure to S&P 500 would mean 5,000 questions to answer. I don't know what the general stats are, but some proxies I've seen have 20+ questions.
Now, you will most likely be uninformed about most of the decisions that need to be made, which lead to your 2nd point about default options suggested by the index fund manager. But that just circles back to Bogle's points in the article. Also, with index fund costs at rock bottoms, good luck getting quality research into your voting options.
> But that just circles back to Bogle's points in the article. Also, with index fund costs at rock bottoms, good luck getting quality research into your voting options.
The alternative is active funds where you're already paying for exactly the same thing plus a bunch of compensation for underperformance to people who pretend to know what they're doing. Paying a research team is cheap in comparison and once funds are at <0.10% expense ratios making them cheaper isn't that big of a market advantage anyway. A good research team and interface would definitely make me pick a 0.10% fund over a 0.05% one for a life-long investment career. If I'm reading the numbers in the article correctly at the scale of Vanguard that's a cool billion dollars a year to provide research and systems.
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?
>the common sense of waiting for a massive crisis before doing something by which time it is too late for millions of investors who lose everything
That is the conventional approach, I think Mr. Bogle is suggesting that we act to prevent such issues ahead of time for a change.
And the main barrier to entry he refers to is essentially the size of the established players. They have economies of scale that a new entrant would be hard-pressed to match. And the author is the man who essentially invented the index fund, and whose company, Vanguard, currently is the market leader in these products and has the most to gain from maintaining the status quo.
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.
"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 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.
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 recurring. 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.
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.
I don't want to vote for each of the thousands of stocks I own indirectly through my index fund. I want Vanguard to vote on my behalf such that it proportionately replicates the votes of the non-index shareholders. This strategy is just an extension of the idea behind index funds in the first place: mirror the existing market.
Which is a dumb idea, of course, as that just leaves the control over your capital to your adversaries. Passive investing works because goals are aligned: The only way to influence an index fund on the investing side of things into doing something stupid is by doing something stupid yourself. If you want to make an S&P500 index fund buy some penny stock, you have to buy it yourself first in massive quantities paying massive prices for it to drive up the market cap. Voting does not work that way.
No, I want Vanguard to hire an independent expert for each company I'm invested in and make the right decisions for me. It is not possible for a human to make an informed decision on voting for each of the thousands of stocks out there. That is one advantage of the fund is they can do that for me.
I have noticed when I vote the shares of the few shares I own that I'm almost always voting with the board of directors. When I've seen a proposal the directors have recommended a No vote on it is always some activist who has their own interests in mind at the expense of me. Sometimes the directors recommend things I disagree with, but those are generally minor details where either way is not harmful to my interests.
The other stockholders are almost never your adversaries. Their interests are in alignment with yours: to vote in such a way that it maximizes the value of the stock.
The only exception would be some kind of action that is specifically discriminatory towards your shares over theirs, which is typically not legal. If it were to occur, that is the only situation where I would want Vanguard to be voting on my behalf.
You're right though that not voting is equivalent and much easier than trying to replicate votes.
> The other stockholders are almost never your adversaries. Their interests are in alignment with yours: to vote in such a way that it maximizes the value of the stock.
Nope. Their interest is to vote in such a way that it maximizes the value of their portfolio. If that doesn't match your portfolio, then your interests are not aligned.
> The only exception would be some kind of action that is specifically discriminatory towards your shares over theirs, which is typically not legal.
There is nothing discriminatory about voting for selling a division of company A to company B, say, and it is certainly not illegal. But it might well still be in the interest of the owners of company B who also happen to hold the only voting 10% of company A, and to the detriment of the owners of the other 90% of company A.
Interesting idea. But you could never know in advance what the results of a vote would be. The only way to do this would be another alteration to law to allow such behavior. However, I am fairly certain this would violate the capital structure and foundational rules put in place by companies with regards to what constitutes a quorum, when/how voting is done, etc. Because companies are allowed to determine how things are done so this would be directly overriding that.
I suppose it's possible to construct a law that says companies can conduct their voting as they have been, but they must also allow/accept late "votes" from fund managers but the requirement is that those late votes must conform to the same proportions.
How would you handle the fractional share ownership concept? A person with $10,000 of SPY shares probably doesn't even own a full share of most components[1]. And even ones that she does own more than a share of like AAPL, it won't be an integer.
[1] for example, you would need a $270,000 investment before you own a full share of SRCL.
People are used to thinking of votes in terms of integers, but if you think of it in terms of points then fractions don't make a difference, really. If you own 100 shares of a stock you get to 100 votes. That's been the standard forever. This is just extending it to say that if you own .01 shares you get .01 votes. It's still the same concept and same math, just not on an integer basis.
I find your comment fascinating but even though I think I understand perfectly what an index fund is, I don't quite understand what it is that S&P sells for so much money.
Could you clarify this for me? I.e. who buys from you, and what is it they buy?
I think the comment is referring to the canonical list of the constituent securities of an index such as the S&P 500 or DJIA. You pay license fees to S&P to name any fund you create “S&P XYZ Fund”.
I suspect you could legally create a fund with the constituents of the S&P 500 without paying them, but you wouldn’t be able to advertise that fact easily.
You would not be able to legally recreate the 500 and just not use the name. We once had a problem within our Custom division (where clients retain the IP but pay us to do everything for them) and one client basically created something that was substantially similar in rules/methodology to another client's product and one client sued the other. Our employees were called to present testimony in court but it was settled before it got that far, presumably because the offending client realized they were going to get hammered.
I’ve read your other comments in this thread and I mostly follow and agree. I’m getting lost on this one though.
How does this monopoly(?) on the 500 work? Aren’t I able to go out tomorrow and buy the different input securities of an index, and market that as “jkulubya’s awesome fund wink wink”? (Easier said than done)
One wrinkle I see with this scheme is that I probably have to publish my own index value because yours is your ip.
Think of the 500 (or any index strategy) as being like a story and the methodology is like the book that tells the story. You can't rip off our story and write your own book that essentially plagiarizes the 500 and claim it as your own. If you were to, for example, write a story about a rich kid who's parents were murdered and when he grew up he became a vigilante who wore a disguise to conceal his identity and worked with the chief of police to fight corruption in his city, I have a feeling you might get sued. This happens in the movie industry from time to time. That's why script readers are exceedingly careful on what they read because there have been a number of cases where someone submits a story which then gets passed along but eventually passed-on and then a while later the studio ends up making a movie written by someone else who submitted a scrip with similar story elements and the studio gets sued by the first writer claiming they ripped them off and just paid someone else to rewrite their story. Sometimes it's true, sometimes it's not.
The reason this same legal principal applies to index products is because it's surprisingly difficult to even match an index's composition and weighting even with the methodology document in hand. So the odds of you creating your own strategy and that just so happens to be damn near identical to another index is essentially impossible. So just like the entertainment businesses, they look at it on a case by case basis and examine whether or not the "spirit" of the strategy has been violated or it's creative elements have been stolen. It's done case by case because it can get pretty nuanced and subjective just like music, books, and films.
jkulubya's comment is largely correct. And you most likely do understand what an index fund is. It's just that most people don't realize there are two sides to the product - the theoretical and the real. The index is a theoretical product (intellectual property). The fund is the real-world implementation. A fund manager takes a look at one of our S&P products and says "I want to make a fund off this" and S&P contracts a license with them to allow it since S&P owns the IP on that index - it is S&P's design and methodology.
An easy way to think of this is the retail example where you pay an investment advisor. You pay them to manage your money but they place all the trades through some broker. S&P is the investment advisor and the fund manager is the broker.
Very interesting. I always assumed that the SP500 index composition was some sort of loss leader for SP where the brand awareness created by the SP500 name served as proof of legitimacy for some other service.
Never thought the index composition could be a cash cow in itself. Im intrigued at how the IP is protected, in legal terms (i.e. what exactly is copyrighted or patented or trademarked or trade secrets), if you are able to comment on that aspect?
The S&P 500, along with a lot of their other products are proprietary and not easily reproducible. S&P doesn’t publish how it generates its indices, so they can charge a lot of money.
Would it be that hard to generate an index that had similiar exposure as an S&P index? Maybe not, but S&P is good at what they do and they have a lot of brand recognition.
This isn't exactly accurate. One of the requirements for publicly traded funds (ETFs) is that they need to be "replicable", meaning that anyone should be able to read the methodologies (which are required to be public) and understand it and be able to come to the same final basket of securities at the same weights.
This, in practice, is very difficult even with everything public, though, due to a variety of differences such as data differences between vendors, "expert judgment" for unforeseen circumstances, and the mere fact that sometimes methodologies can be confusing, complex, or have vague language. Most indices, unlike the 500, are pretty hard on rules. The 500 is a rare index that is purely discretionary. They do give guidance on general guidelines, though.
