INDEX FUND MANAGERS ARE TOO BIG FOR COMFORT / THE FINANCIAL TIMES OP EDITORIAL

Index fund managers are too big for confort

Investors such as BlackRock cannot keep quiet and hope that no one will notice them

John Gapper



Think of an industry in which three big companies have used technology and economies of scale to become oligopolies and wield power over other enterprises. It hails not from Silicon Valley but the US east coast.

The industry in question is passive investment management, in which computers take the role of human stock pickers and money is channelled into index and exchange traded funds. The Big Three of the US industry — BlackRock, Vanguard and State Street — have gained such size and efficiency that they control 80 per cent of the money invested in US index funds.

Even Jack Bogle, founder of Vanguard and pioneer of the modern US index fund industry, is alarmed by their success. He has warned that, “if historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large US corporation”.

That is a scary prospect for the future relationship between companies and their investors. Chief executives such as Paul Polman, the departing head of Unilever, sigh at the short-termism of some shareholders and activists. Would life be better if they reported to huge robots?

It might become quieter. Investors have traditionally expressed their displeasure with companies by selling shares, or by kicking up a fuss through public or private criticisms. The first tactic is barred to index funds: they have to hang on to stock in any company in an index, no matter how badly it is run. The weighting is set by a formula, not by individual discretion.

Passive investors also have less incentive than activists to speak up and persuade a company to change strategy, since no single investment has much effect on their performance. Leo Strine, supreme court chief justice in Delaware, the state in which many US companies are incorporated, has described index funds as “the least active in exercising voice and judgment”.

Companies should really want index fund companies not to remain silent, but to speak up. The worst of all worlds would be a shareholder base dominated by passive investors who are also passive owners, where most noise is made by a few activists who demand quick fixes. Index funds are naturally the most long term in outlook because they have no other choice.

The Big Three have realised they cannot keep quiet and hope that no one will notice them. Larry Fink, chief executive of BlackRock, has taken to publishing an annual letter to chief executives, which is a clue to where power lies. In this year’s missive, he promised: “We must be active, engaged agents on behalf of the clients invested with BlackRock.” That involves hiring more overseers — BlackRock intends to double its “investment stewardship” staff in the next three years — and arranging more conversations with chief executives. It voted at 15,000 investor meetings on 130,000 proposals last year, while Vanguard “engaged” with 720 portfolio companies representing $1.6tn of its assets under management.

As with investing, the giants are nothing if not efficient. They have their own governance guidelines and they do a lot of talking behind the scenes, following Theodore Roosevelt’s motto, “Speak softly and carry a big stick”. As one Dutch study suggested, they “exert structural power . . . in a way that is hidden from public view”.

This gets results. A study of US companies held by passive mutual funds found that they performed better than their peers thanks to stricter governance, such as having more independent directors and fewer takeover defences. The fund groups are good at curbing misbehaviour.

But their size and strength lead to two problems. First, they operate at such a scale that they tend to take a common approach to all companies. This is effective in imposing minimum standards in matters such as executive pay, but it does not amount to engaging deeply with corporate strategy in the same way as activist investors.

Companies could be left ticking boxes for passive investors, while still being exposed to intense, targeted pressure from activists who have more time. Mr Fink insists that talking consistently to long-term shareholders such as BlackRock will help companies not to be picked on by those with “the shortest and narrowest of objectives”, but the jury is still out on that.

Second, so few investors holding so much power would be worrying even if they were paragons. I sympathise with Vanguard’s decision to shine its spotlight on US makers of guns and opioids, but what happens if the giants team up against an innocent industry? It puts a premium on their judgment.

Antitrust scholars worry about collusion — institutions with stakes in different companies in an industry encouraging them not to compete hard with each other (one study found that US airline prices are higher as a result). The evidence is mixed but, as the fund groups expand, their capacity to exert invisible influence over the companies in which they hold stakes strengthens.

Like other consumer technologies, index funds have brought great benefits to ordinary investors. But Mr Bogle’s innovation, useful as it remains, may be working a little too well.