asking the important questions
February 21, 2019 12:36 PM Subscribe
Matt Levine, Money Stuff, Bloomberg: Should index funds be illegal?
Anticompetitive Effects of Common Ownership, José Azar, Martin C. Schmalz, Isabel Tecu, Journal of Finance, 73(4), 2018
more Matt Levine: Index Funds May Work a Little Too Well
Are Index Funds Evil? What Would Happen If We Were All Passive Investors? Is Passive Investment Actively Hurting The Economy? Is the passive investing boom creating a 'frightening risk'? Are Index Funds Communist? Is Indexing EVEN WORSE than Marxism?
Maybe Index Funds Will Destroy Capitalism
I have been writing about it since 2015, and I’ve enjoyed phrasing the question maximally as “should index funds be illegal?” That is a little bit of a joke, but not really, because if you take this stuff seriously enough then it does seem like large diversified shareholders—index funds but also other mutual funds—would pose a problem under the antitrust laws, and you’d have to do something about them. One thing I should say about this theory is that, as far as I can tell, almost no one who works in the capital markets or corporate America takes it seriously.
Anticompetitive Effects of Common Ownership, José Azar, Martin C. Schmalz, Isabel Tecu, Journal of Finance, 73(4), 2018
more Matt Levine: Index Funds May Work a Little Too Well
But I like the index-fund conspiracy theorists because their claims are so bold. They claim -- outrageously (for law and business school professors!) -- that modern corporate capitalism is bad for the economy, but not for any sort of agency cost reasons. Rather, it's bad in its best form. Managers aren't acting against shareholders' interests, and shareholders aren't excessively focused on the short term. Managers are loyally and correctly maximizing the value of their shareholders' portfolios. And those shareholders are investing rationally and correctly in diversified portfolios that maximize risk-adjusted return. Everything about the system is working perfectly. And it's still bad.The Great Debate Over Passive Investing And Its Economic Impact
Are Index Funds Evil? What Would Happen If We Were All Passive Investors? Is Passive Investment Actively Hurting The Economy? Is the passive investing boom creating a 'frightening risk'? Are Index Funds Communist? Is Indexing EVEN WORSE than Marxism?
Maybe Index Funds Will Destroy Capitalism
Yes what if every citizen/resident of the country held an equal share in an index fund called the GDP we all got dividends based accordingly. WHAT IF. Motherfuckers.
posted by seanmpuckett at 12:48 PM on February 21, 2019 [33 favorites]
posted by seanmpuckett at 12:48 PM on February 21, 2019 [33 favorites]
Look. No one wanted to have to trust their retirement nesteggs to Wall Street. But, the powers-that-be made it pretty much mandatory back in the waning years of the 20th century. Index funds are a great tool for anyone not wanting to (or lacking the skills to) build and actively manage portfolios...you know, 99% of everyone.
I'm sure the sharks hate index funds like the plague. Tough.
posted by Thorzdad at 12:49 PM on February 21, 2019 [30 favorites]
I'm sure the sharks hate index funds like the plague. Tough.
posted by Thorzdad at 12:49 PM on February 21, 2019 [30 favorites]
I'm sure the sharks hate index funds like the plague. Tough.
The thesis here, though, is not that index funds are bad because mutual fund managers hate them. It's that index funds are bad because they encourage anticompetitive and anticonsumer behavior among businesses, and it is a thesis that is at least congruent with a Marxist critique of capital.
posted by gauche at 12:53 PM on February 21, 2019 [8 favorites]
The thesis here, though, is not that index funds are bad because mutual fund managers hate them. It's that index funds are bad because they encourage anticompetitive and anticonsumer behavior among businesses, and it is a thesis that is at least congruent with a Marxist critique of capital.
posted by gauche at 12:53 PM on February 21, 2019 [8 favorites]
There are what appear to me, to be a lot of self-contradictory and specious arguments in these pieces.
All of the 'price discovery' arguments seem to be using a straw-man version of how much of the market is really tied to 'blind' ETFs. That or they point directly at much larger problems that are already plaguing financial capitalism, but they're picking out the only product that 'regular' people buy.
shown that greater ETF ownership of a stock can actually lead to a reduction in the number of analysts following a stock. Essentially, as more ETFs own a security, a larger percentage of the daily trading activity in that security is done for the purpose of ETF creation and arbitrage rather than for fundamental reasons related to the business of the company
Yeah...so all of the money is either doing the thing or counter-betting the thing. Isn't that...every product/market? The amount of money chasing 'fundamentals' is trivial.
posted by Reasonably Everything Happens at 12:55 PM on February 21, 2019 [2 favorites]
All of the 'price discovery' arguments seem to be using a straw-man version of how much of the market is really tied to 'blind' ETFs. That or they point directly at much larger problems that are already plaguing financial capitalism, but they're picking out the only product that 'regular' people buy.
shown that greater ETF ownership of a stock can actually lead to a reduction in the number of analysts following a stock. Essentially, as more ETFs own a security, a larger percentage of the daily trading activity in that security is done for the purpose of ETF creation and arbitrage rather than for fundamental reasons related to the business of the company
Yeah...so all of the money is either doing the thing or counter-betting the thing. Isn't that...every product/market? The amount of money chasing 'fundamentals' is trivial.
posted by Reasonably Everything Happens at 12:55 PM on February 21, 2019 [2 favorites]
Serious question (because I only vaguely understand this area of finance): if I held an index fund account (for example, let's say I put $100K of my retirement savings in one just last year) and they became illegal next month - what would happen to my money? Would I be able to move it back into a 401K with not-too-significant damage, theoretically?
posted by allkindsoftime at 12:59 PM on February 21, 2019
posted by allkindsoftime at 12:59 PM on February 21, 2019
Isn't the purpose of antitrust legislation because trusts can can act in anticompetitive fashion to distort the proper functioning of markets setting prices? I'm unclear how an index fund, which seeks only to replicate the behavior of an underlying bundle of securities, would be a source of this.
posted by leotrotsky at 1:01 PM on February 21, 2019
posted by leotrotsky at 1:01 PM on February 21, 2019
the Anti-Trust to do list should have roughly 12,000 entries. disrupt passive index investing probably still doesn't make the cut.
posted by Anchorite_of_Palgrave at 1:02 PM on February 21, 2019 [7 favorites]
posted by Anchorite_of_Palgrave at 1:02 PM on February 21, 2019 [7 favorites]
Asking what would happen if index funds become illegal is, in my mind, akin to asking what farmers would do if chickens became illegal. Like... sure I guess it could happen, and chicken farmers would need to figure out what to do to adjust, but the whole idea is so outlandish that it's difficult to meaningfully speculate about.
posted by Wretch729 at 1:08 PM on February 21, 2019 [14 favorites]
posted by Wretch729 at 1:08 PM on February 21, 2019 [14 favorites]
dear ask metafilter is there a way to buy every kind of chicken
posted by Huffy Puffy at 1:12 PM on February 21, 2019 [36 favorites]
posted by Huffy Puffy at 1:12 PM on February 21, 2019 [36 favorites]
The framing question is -- I think intentionally -- provocative, but the ideas are at least worth considering. From a Slate article on the subject:
posted by gauche at 1:14 PM on February 21, 2019 [15 favorites]
In a new paper, Azar and co-authors Martin C. Schmalz and Isabel Tecu have uncovered a smoking gun. To test the hypothesis that institutional investors gain market power that results in higher prices, they examine airline routes. Although we think of airlines as independent companies, they are actually mostly owned by a small group of institutional investors. For example, United’s top five shareholders—all institutional investors—own 49.5 percent of the firm. Most of United’s largest shareholders also are the largest shareholders of Southwest, Delta, and other airlines. The authors show that airline prices are 3 percent to 11 percent higher than they would be if common ownership did not exist. That is money that goes from the pockets of consumers to the pockets of investors.Emphasis added.
posted by gauche at 1:14 PM on February 21, 2019 [15 favorites]
I love Matt Levine. Does anyone have any similar email newsletters to recommend?
The idea is so much fun to think about! If we all put our money in a broad basket of capital, then all of a sudden the people managing that basket wouldn't care about getting returns from individual eggs in the basket (companies), instead they want to improve returns from the basket (i.e. capital overall) - so they'll encourage the companies that they are owners of to stop competing, getting higher returns for all of our parent's 401ks and Pension Funds, but leaving the poor consumer SOL.
It's also one of those things that's funny because it's clearly Not Something That Happens. But much of financial history is people noticing that something Just Doesn't Happen, and then making a whole bunch of money Making It Happen, and finally leaving the rest of us to deal with the massive externalities of That Thing Happening.
posted by The Ted at 1:16 PM on February 21, 2019 [16 favorites]
The idea is so much fun to think about! If we all put our money in a broad basket of capital, then all of a sudden the people managing that basket wouldn't care about getting returns from individual eggs in the basket (companies), instead they want to improve returns from the basket (i.e. capital overall) - so they'll encourage the companies that they are owners of to stop competing, getting higher returns for all of our parent's 401ks and Pension Funds, but leaving the poor consumer SOL.
It's also one of those things that's funny because it's clearly Not Something That Happens. But much of financial history is people noticing that something Just Doesn't Happen, and then making a whole bunch of money Making It Happen, and finally leaving the rest of us to deal with the massive externalities of That Thing Happening.
posted by The Ted at 1:16 PM on February 21, 2019 [16 favorites]
And, it would be relatively easy to make index funds illegal: restrict ownership of stock in concentrated industries such as airlines. You can only own stock in one airline at a time.
Disclosure: I own a small amount of stock in a number of index funds. I'm not without skin in this game.
posted by gauche at 1:17 PM on February 21, 2019 [1 favorite]
Disclosure: I own a small amount of stock in a number of index funds. I'm not without skin in this game.
posted by gauche at 1:17 PM on February 21, 2019 [1 favorite]
Yes what if every citizen/resident of the country held an equal share in an index fund called the GDP we all got dividends based accordingly.
What if every corporate board was elected through the US general electoral system?
It's so beautiful and horrifying at the same time.
posted by GuyZero at 1:19 PM on February 21, 2019 [4 favorites]
What if every corporate board was elected through the US general electoral system?
It's so beautiful and horrifying at the same time.
posted by GuyZero at 1:19 PM on February 21, 2019 [4 favorites]
You can only own stock in one airline at a time.
Even really big index funds only hold a tiny fraction of any one company. There's no controlling interest. Besides, concentrated industry collusion is a rising tide that lifts all boats. If airlines work to keep fares high that helps you whether you own shares in one or all of them.
* edit: whoops, just saw the link about the paper studying this very thing. huh.
posted by GuyZero at 1:21 PM on February 21, 2019
Even really big index funds only hold a tiny fraction of any one company. There's no controlling interest. Besides, concentrated industry collusion is a rising tide that lifts all boats. If airlines work to keep fares high that helps you whether you own shares in one or all of them.
* edit: whoops, just saw the link about the paper studying this very thing. huh.
posted by GuyZero at 1:21 PM on February 21, 2019
I'm not a fan of Levine's framing of the issue as specific to index funds. It's clickbait-y, and he does no service to the underlying arguments by introducing it that way.
The basis of the whole argument is a paper, which Levine links to an abstract of. Here's the full text, courtesy of the OECD.
Put simply, the argument is that when you have common owners across companies within an industry, it creates an incentive for those companies to act like a monopoly, rather than compete with each other. This isn't particularly controversial when you are talking about majority or controlling shares in a company—if Warbucks Ltd. owns 51% of American Airlines and 51% of Delta, it's pretty much a de facto merger, because Warbucks isn't going to let either of their companies harm the other. And so there's an obvious anti-trust interest there.
What the paper is alleging is that you can get the same effect even if there's no majority or controlling ownership. So if you have five different funds, and each of them own 20% of AA and 20% of Delta, even though no single fund has a controlling interest in either airline, the airlines might behave much the same way that they would if they had a single common owner. Because the same behavior that would please a single common owner is likely to please five 20% owners.
I'm somewhat skeptical of this—not that it happens, but that it's caused by the cross ownership in particular—mostly because I'm intrinsically skeptical that corporate executives are actually that influenced by the desires of minority shareholders. Supposedly the authors of the paper have shown, in the case of airlines specifically, some signs of collusion as the result of minority cross-ownership, but the airline industry is pretty fucking prone to collusion anyway. There's no doubt in my mind that absent a constant watchful regulatory eye, that the airlines will collude and raise prices even if they were all independently owned. It's easier to collude and raise prices than it is to cut costs and compete. Any executive with a more-than-room-temperature IQ is going to understand that cutting costs and reducing prices is a race to the bottom; much better, if you can get away with it, to do whatever you can to avoid profit-destroying competition and keep prices pegged at the maximum buyers are willing to pay for the good or service (the monopoly condition).
So I tend to think that the collusion isn't the result of index funds and the ensuing institutional cross-ownership, but due to weak regulation and the natural tendency of large industries dominated by a small number of large firms (and an even smaller group of revolving-door executives in senior roles) to collude and raise prices absent continuous and ongoing regulatory pressure.
Happily, it's sort of academic whether the price increases are the result of cross-ownership or executives colluding on prices over golf at their favorite country clubs, because the solution is the same: regulate harder. If you see an industry where profit margins are elevated for any length of time (longer than it ought to take competitors to catch up with whatever efficiency improvements are being made), that should be intrinsically suspicious. A competitive market should always drive profits down over time, to a level driven by the cost of capital. If it doesn't, something is wrong.
Going after index funds as the source of the problem is stupid, and I'm suspicious that anyone who blames index funds is probably trying to deflect blame from corporate governance and weak regulatory bodies, who should be looking hard at any industry reminiscent of monopoly pricing, regardless of how many owners there are and how control is distributed.
posted by Kadin2048 at 1:23 PM on February 21, 2019 [35 favorites]
The basis of the whole argument is a paper, which Levine links to an abstract of. Here's the full text, courtesy of the OECD.
Put simply, the argument is that when you have common owners across companies within an industry, it creates an incentive for those companies to act like a monopoly, rather than compete with each other. This isn't particularly controversial when you are talking about majority or controlling shares in a company—if Warbucks Ltd. owns 51% of American Airlines and 51% of Delta, it's pretty much a de facto merger, because Warbucks isn't going to let either of their companies harm the other. And so there's an obvious anti-trust interest there.
What the paper is alleging is that you can get the same effect even if there's no majority or controlling ownership. So if you have five different funds, and each of them own 20% of AA and 20% of Delta, even though no single fund has a controlling interest in either airline, the airlines might behave much the same way that they would if they had a single common owner. Because the same behavior that would please a single common owner is likely to please five 20% owners.
I'm somewhat skeptical of this—not that it happens, but that it's caused by the cross ownership in particular—mostly because I'm intrinsically skeptical that corporate executives are actually that influenced by the desires of minority shareholders. Supposedly the authors of the paper have shown, in the case of airlines specifically, some signs of collusion as the result of minority cross-ownership, but the airline industry is pretty fucking prone to collusion anyway. There's no doubt in my mind that absent a constant watchful regulatory eye, that the airlines will collude and raise prices even if they were all independently owned. It's easier to collude and raise prices than it is to cut costs and compete. Any executive with a more-than-room-temperature IQ is going to understand that cutting costs and reducing prices is a race to the bottom; much better, if you can get away with it, to do whatever you can to avoid profit-destroying competition and keep prices pegged at the maximum buyers are willing to pay for the good or service (the monopoly condition).
So I tend to think that the collusion isn't the result of index funds and the ensuing institutional cross-ownership, but due to weak regulation and the natural tendency of large industries dominated by a small number of large firms (and an even smaller group of revolving-door executives in senior roles) to collude and raise prices absent continuous and ongoing regulatory pressure.
Happily, it's sort of academic whether the price increases are the result of cross-ownership or executives colluding on prices over golf at their favorite country clubs, because the solution is the same: regulate harder. If you see an industry where profit margins are elevated for any length of time (longer than it ought to take competitors to catch up with whatever efficiency improvements are being made), that should be intrinsically suspicious. A competitive market should always drive profits down over time, to a level driven by the cost of capital. If it doesn't, something is wrong.
Going after index funds as the source of the problem is stupid, and I'm suspicious that anyone who blames index funds is probably trying to deflect blame from corporate governance and weak regulatory bodies, who should be looking hard at any industry reminiscent of monopoly pricing, regardless of how many owners there are and how control is distributed.
posted by Kadin2048 at 1:23 PM on February 21, 2019 [35 favorites]
Going after index funds as the source of the problem is stupid
Levine isn't actually going after index funds. He's someone who enjoys a good thought experiment unconstrained by too many considerations of realism. His columns are usually a good 25% humor.
posted by praemunire at 1:27 PM on February 21, 2019 [11 favorites]
Levine isn't actually going after index funds. He's someone who enjoys a good thought experiment unconstrained by too many considerations of realism. His columns are usually a good 25% humor.
posted by praemunire at 1:27 PM on February 21, 2019 [11 favorites]
The thing I worry about with index funds is this: As I understand it they pick an index, which is a list of stocks that make up the market. They try to hold a little of every one of those company's stocks, in an amount that will mirror the relative values of the companies in that index. Right?
So this is just an algorithm, you don't have to have some bankster who is choosing them based on ego, hunches, tea leaves, criminal masterminds or whatever. A computer does it.
And we have seen plenty of stories of algorithms run amok. It seems like this would increase volatility. With computers at the wheel for a large enough portion of the investors, is there not a risk they all go running over the cliff like Disney lemmings?
I still have my 401K in them; I have seen the math and I absolutely see why this is my better choice. But is there some terrible singularity we will hit when a critical mass of investors do it, and then we're all screwed because none of us have our hands on the wheel?
posted by elizilla at 1:38 PM on February 21, 2019
So this is just an algorithm, you don't have to have some bankster who is choosing them based on ego, hunches, tea leaves, criminal masterminds or whatever. A computer does it.
And we have seen plenty of stories of algorithms run amok. It seems like this would increase volatility. With computers at the wheel for a large enough portion of the investors, is there not a risk they all go running over the cliff like Disney lemmings?
I still have my 401K in them; I have seen the math and I absolutely see why this is my better choice. But is there some terrible singularity we will hit when a critical mass of investors do it, and then we're all screwed because none of us have our hands on the wheel?
posted by elizilla at 1:38 PM on February 21, 2019
The robofunds that auto-rebalance with undisclosed frequency offered by Schwab et al are as of yet untested in a major acute market event. ETFs, on the other hand, rebalance daily and are unlikely to freak out as the cost basis would increase with higher rebalancing frequency.
posted by grumpybear69 at 1:48 PM on February 21, 2019
posted by grumpybear69 at 1:48 PM on February 21, 2019
Bogle Sounds a Warning on Index Funds
posted by the man of twists and turns at 1:49 PM on February 21, 2019 [1 favorite]
posted by the man of twists and turns at 1:49 PM on February 21, 2019 [1 favorite]
AFAIK, the indexes are not really “algorithmic” in the contemporary sense. Index investing was invented before computerized trading as we know it today. The index is based on something more mundane like market cap, which doesn’t change instantly the way other indicators might.
There are arguments about the risks associated with the long term increase in index fund ownership of the market, but that’s not really “flash crash” type risk.
posted by overeducated_alligator at 1:51 PM on February 21, 2019 [1 favorite]
There are arguments about the risks associated with the long term increase in index fund ownership of the market, but that’s not really “flash crash” type risk.
posted by overeducated_alligator at 1:51 PM on February 21, 2019 [1 favorite]
Huh, last I saw the major index funds rebalanced monthly, and manually, although no doubt with machine assistance. No high-frequency trading AFAIK.
posted by traveler_ at 1:52 PM on February 21, 2019
posted by traveler_ at 1:52 PM on February 21, 2019
I have a slightly different hobby horse, which is that currency trading should be essentially illegal for newb/retail investors, to protect them from themselves. Buying shares or tracking the S&P you can benefit from something of a "lifts all boats" effect, but currency trading is by definition zero sum, and the guy (or algorithm) at the other end of the trade knows a hell of a lot more than you.
posted by kersplunk at 1:54 PM on February 21, 2019 [1 favorite]
posted by kersplunk at 1:54 PM on February 21, 2019 [1 favorite]
Yes what if every citizen/resident of the country held an equal share in an index fund called the GDP we all got dividends based accordingly.
What if every corporate board was elected through the US general electoral system?
It's so beautiful and horrifying at the same time.
As political power was expanded to include people other than rich white men so should democracy exland to curtail the power of the wealth hoarders. I’d like that national 52% of controlling interest in every company over a certain size now, with elections on who to represent us.
As for national index funds, I call it Give Every American A Rich Uncle. Experience money how the rich do, as a tool, not a tyrant.
posted by The Whelk at 1:55 PM on February 21, 2019 [5 favorites]
What if every corporate board was elected through the US general electoral system?
It's so beautiful and horrifying at the same time.
As political power was expanded to include people other than rich white men so should democracy exland to curtail the power of the wealth hoarders. I’d like that national 52% of controlling interest in every company over a certain size now, with elections on who to represent us.
As for national index funds, I call it Give Every American A Rich Uncle. Experience money how the rich do, as a tool, not a tyrant.
posted by The Whelk at 1:55 PM on February 21, 2019 [5 favorites]
So I tend to think that the collusion isn't the result of index funds and the ensuing institutional cross-ownership, but due to weak regulation and the natural tendency of large industries dominated by a small number of large firms (and an even smaller group of revolving-door executives in senior roles) to collude and raise prices absent continuous and ongoing regulatory pressure.
I worked at an insurance company and a coworker was going off to an insurance conference where they would be discussing pricing models with execs from other insurance companies. I said "Wait....isn't that..." and my coworker said "SHHHHH!"
posted by srboisvert at 2:02 PM on February 21, 2019 [10 favorites]
I worked at an insurance company and a coworker was going off to an insurance conference where they would be discussing pricing models with execs from other insurance companies. I said "Wait....isn't that..." and my coworker said "SHHHHH!"
posted by srboisvert at 2:02 PM on February 21, 2019 [10 favorites]
Huh, last I saw the major index funds rebalanced monthly, and manually, although no doubt with machine assistance. No high-frequency trading AFAIK.
It depends on what type of "index" fund you are talking about. The vast majority of index funds are constituted based on market capitalization. Effectively, what this means is that the fund never needs to rebalance. As prices of individual stocks in the index go up and down, their market capitalization changes accordingly, and therefore their representation in the fund adjusts automatically. No rebalancing is necessary.
One of the big advantages of market cap index funds is that they never need to trade shares on the whims of the daily, monthly or yearly stock performances. They only need to buy or sell small amounts as the number of fund shareholders increases or decreases, or if the definition of the index itself changes. This reduces the overhead and expenses of daily trading.
posted by JackFlash at 2:39 PM on February 21, 2019
It depends on what type of "index" fund you are talking about. The vast majority of index funds are constituted based on market capitalization. Effectively, what this means is that the fund never needs to rebalance. As prices of individual stocks in the index go up and down, their market capitalization changes accordingly, and therefore their representation in the fund adjusts automatically. No rebalancing is necessary.
One of the big advantages of market cap index funds is that they never need to trade shares on the whims of the daily, monthly or yearly stock performances. They only need to buy or sell small amounts as the number of fund shareholders increases or decreases, or if the definition of the index itself changes. This reduces the overhead and expenses of daily trading.
posted by JackFlash at 2:39 PM on February 21, 2019
The index fund thing is fun because it seems to imply a dilemma that is good for left leaning people:
— either there’s a problem with competition, in which case we need a huge return to government regulation and trust busting
— or there is no problem, in which case it should be possible to nationalize huge swaths of the economy, just replace “index fund” with “sovereign wealth fund”.
posted by vogon_poet at 2:47 PM on February 21, 2019 [2 favorites]
— either there’s a problem with competition, in which case we need a huge return to government regulation and trust busting
— or there is no problem, in which case it should be possible to nationalize huge swaths of the economy, just replace “index fund” with “sovereign wealth fund”.
posted by vogon_poet at 2:47 PM on February 21, 2019 [2 favorites]
(the assumption is you can’t ban diversified investing, although many hedge fund managers probably would like that.)
posted by vogon_poet at 2:49 PM on February 21, 2019
posted by vogon_poet at 2:49 PM on February 21, 2019
Effectively, what this means is that the fund never needs to rebalance.
Well, stocks do move on and off whatever the underlying list is (e.g., S&P 500), meaning the fund must buy or sell them. As this involves significant volume which is relatively price-insensitive, it offers fun opportunities for traders. But mostly, yes, they are not doing a lot of buying and selling.
posted by praemunire at 3:09 PM on February 21, 2019
Well, stocks do move on and off whatever the underlying list is (e.g., S&P 500), meaning the fund must buy or sell them. As this involves significant volume which is relatively price-insensitive, it offers fun opportunities for traders. But mostly, yes, they are not doing a lot of buying and selling.
posted by praemunire at 3:09 PM on February 21, 2019
"Index funds" is sort of a weird derail. Index funds, because they are compelled to own the index weighting of a name, no more and no less, spend very little time on the strategic layer of governance. No index fund manager has ever spent any time with the CEO of United or Delta trying to persuade them to moderate price competition with each other, or would have any incentive to do so. (Index fund managers do get involved in certain non-strategic initiatives around governance, such as board diversity and lack of conflicts, and quality of corporate disclosures). If the unlikely event an index manager cared about the performance of their stock, they would oppose an industry's fixing prices because of the deadweight loss on the broader economy of monopolistic behavior. In other words, the monopoly rents that United and Delta could extract by agreeing not compete in each other's hubs are outweighed by the adverse impact upon all other sorts of companies who would be injured by the drop in tourism and business traffic that the fixed-too-high prices would cause.
The thought experiment works best for large, actively managed funds, which can concentrate in industries and issuers, and which have the compass to participate in the strategy of their portfolio companies. In other words, buy a lot of Delta and United and encourage their collusion and be underweight (or even short) the hotel companies and car rental companies their behavior hurts.
posted by MattD at 3:22 PM on February 21, 2019 [4 favorites]
The thought experiment works best for large, actively managed funds, which can concentrate in industries and issuers, and which have the compass to participate in the strategy of their portfolio companies. In other words, buy a lot of Delta and United and encourage their collusion and be underweight (or even short) the hotel companies and car rental companies their behavior hurts.
posted by MattD at 3:22 PM on February 21, 2019 [4 favorites]
we have seen plenty of stories of algorithms run amok.
It's been predicted that within the next 5 years or so, index funds will own > 50% of the stock market. As they grow in size and hold an ever larger percentage of stock the question has to be asked who is driving the stock price?
Imagine a situation where 90% of stocks are held by index trackers and 10% by active managers - the fund managers could buy or sell a stock, all the indexes would immediately follow - their algorithms magnifying the price change - the managed funds could (and would) then just reverse their position and instantly profit. it would turn on its head the received wisdom that index funds are impossible to beat.
posted by Lanark at 3:25 PM on February 21, 2019 [1 favorite]
It's been predicted that within the next 5 years or so, index funds will own > 50% of the stock market. As they grow in size and hold an ever larger percentage of stock the question has to be asked who is driving the stock price?
Imagine a situation where 90% of stocks are held by index trackers and 10% by active managers - the fund managers could buy or sell a stock, all the indexes would immediately follow - their algorithms magnifying the price change - the managed funds could (and would) then just reverse their position and instantly profit. it would turn on its head the received wisdom that index funds are impossible to beat.
posted by Lanark at 3:25 PM on February 21, 2019 [1 favorite]
Well, stocks do move on and off whatever the underlying list is (e.g., S&P 500), meaning the fund must buy or sell them.
Unless you talk about the Total Stock Market Index, in which case there is no movement on or off the list except for the very tiniest companies at the bottom that are virtually insignificant.
Just to give an idea of the what tiny means, the Vanguard Total Stock Market Index Fund holds over $20 billion dollars of Microsoft stock but less than $1000 dollars worth of the smallest companies. That's less than a millionth the size. Those tiny companies moving in and out of the index are essentially invisible.
posted by JackFlash at 3:48 PM on February 21, 2019 [1 favorite]
Unless you talk about the Total Stock Market Index, in which case there is no movement on or off the list except for the very tiniest companies at the bottom that are virtually insignificant.
Just to give an idea of the what tiny means, the Vanguard Total Stock Market Index Fund holds over $20 billion dollars of Microsoft stock but less than $1000 dollars worth of the smallest companies. That's less than a millionth the size. Those tiny companies moving in and out of the index are essentially invisible.
posted by JackFlash at 3:48 PM on February 21, 2019 [1 favorite]
Imagine a situation where 90% of stocks are held by index trackers and 10% by active managers - the fund managers could buy or sell a stock, all the indexes would immediately follow - their algorithms magnifying the price change - the managed funds could (and would) then just reverse their position and instantly profit. it would turn on its head the received wisdom that index funds are impossible to beat.
No, as pointed out previously, the vast majority of index funds are market cap funds. They never have to buy or sell stocks simply because the market price changes. They don't magnify price changes. Just the opposite, they tend to dampen price changes because when the price changes, the market cap index funds holding the majority of shares in your scenario do absolutely nothing.
posted by JackFlash at 3:59 PM on February 21, 2019 [5 favorites]
No, as pointed out previously, the vast majority of index funds are market cap funds. They never have to buy or sell stocks simply because the market price changes. They don't magnify price changes. Just the opposite, they tend to dampen price changes because when the price changes, the market cap index funds holding the majority of shares in your scenario do absolutely nothing.
posted by JackFlash at 3:59 PM on February 21, 2019 [5 favorites]
the fund managers could buy or sell a stock, all the indexes would immediately follow - their algorithms magnifying the price change - the managed funds could (and would) then just reverse their position and instantly profit.
In addition to what JackFlash said, this doesn't really reflect an understanding of how buying and selling works on an exchange. The highest-level lay abstraction of selling a stock involves pushing a button and somehow money gets deposited to your account, but ultimately you have to get connected to someone on the other side interested in filling. This makes it much more complicated to do what you're proposing.
posted by praemunire at 4:22 PM on February 21, 2019
In addition to what JackFlash said, this doesn't really reflect an understanding of how buying and selling works on an exchange. The highest-level lay abstraction of selling a stock involves pushing a button and somehow money gets deposited to your account, but ultimately you have to get connected to someone on the other side interested in filling. This makes it much more complicated to do what you're proposing.
posted by praemunire at 4:22 PM on February 21, 2019
it would turn on its head the received wisdom that index funds are impossible to beat.
And to complete the trifecta, no one reputable says that index funds are impossible to beat. The established wisdom is that the majority of individual fund managers are outperformed by index funds. In any given time frame, some individual managers do beat the index funds, but not reliably so; and further, they charge higher fees to do so.
You could make a very close analogy to your statement by saying that the lottery is impossible to beat -- it's obviously not, lots of people win small and medium prizes on every draw and someone wins the jackpot every few draws. But the majority of entrants do worse than the alternative of not buying a ticket, and you can't figure out which ticket will win in advance, so on average, you do better not to play. That doesn't mean there's never anyone posing with giant novelty cheques.
posted by Homeboy Trouble at 4:32 PM on February 21, 2019 [3 favorites]
And to complete the trifecta, no one reputable says that index funds are impossible to beat. The established wisdom is that the majority of individual fund managers are outperformed by index funds. In any given time frame, some individual managers do beat the index funds, but not reliably so; and further, they charge higher fees to do so.
You could make a very close analogy to your statement by saying that the lottery is impossible to beat -- it's obviously not, lots of people win small and medium prizes on every draw and someone wins the jackpot every few draws. But the majority of entrants do worse than the alternative of not buying a ticket, and you can't figure out which ticket will win in advance, so on average, you do better not to play. That doesn't mean there's never anyone posing with giant novelty cheques.
posted by Homeboy Trouble at 4:32 PM on February 21, 2019 [3 favorites]
My thoughts on this align with Kadin2048's, but he expressed them much better. The anti-competitive behavior of airlines can be explained by the shrinking number of players as a result of mergers and acquisitions. I seriously doubt that the CEOs of large companies are thinking "I don't have to care about our shareholders* because institutions own our competitors as well." That's…not how business decisions are made.
*Although they shouldn't care about maximizing shareholder returns, but that's a different rant
posted by Johnny Wallflower at 5:35 PM on February 21, 2019
*Although they shouldn't care about maximizing shareholder returns, but that's a different rant
posted by Johnny Wallflower at 5:35 PM on February 21, 2019
The problem with index funds is that they hand too much power to management.
posted by mono blanco at 6:11 PM on February 21, 2019
posted by mono blanco at 6:11 PM on February 21, 2019
I actually would say the lottery is impossible to beat, and even forms a perfect example of an unbeatable system, which really just goes to demonstrate what I think of by the word "beat" here. English is hard.
posted by traveler_ at 6:13 PM on February 21, 2019
posted by traveler_ at 6:13 PM on February 21, 2019
The problem with index funds is that they hand too much power to management.
This is the problem that Vanguard founder John Bogle was getting at -- passive corporate governance. An analysis of proxy votes shows that Vanguard and Blackrock vote with management 95% to 99% of the time. As Vanguard and Blackrock acquire a higher percentage of total shares, they just become a solid block backing management, allowing a handful of company insiders to have their way. Bogle was concerned about the trend of unrestrained corporate executives looting companies for their own benefit.
Why do index fund managers always vote with management? Well, first of all, it's easy. You don't have to think or evaluate proxy initiatives. Just vote the company line.
Second, there is little incentive for index fund managers to advocate for shareholder initiatives, for example, to reign in executive compensation. This is because the index fund automatically earns the return of the index regardless or whether the companies in the index provide good or bad returns to shareholders. The fund manager is measured by only by how well they mirror the index, not by how well the companies in the index perform.
This is why John Bogle advocated adding a legal fiduciary responsibility to fund managers. If they always passively vote with company managers, they might be subject to lawsuits of ignoring their fiduciary responsibilities.
posted by JackFlash at 6:41 PM on February 21, 2019 [9 favorites]
This is the problem that Vanguard founder John Bogle was getting at -- passive corporate governance. An analysis of proxy votes shows that Vanguard and Blackrock vote with management 95% to 99% of the time. As Vanguard and Blackrock acquire a higher percentage of total shares, they just become a solid block backing management, allowing a handful of company insiders to have their way. Bogle was concerned about the trend of unrestrained corporate executives looting companies for their own benefit.
Why do index fund managers always vote with management? Well, first of all, it's easy. You don't have to think or evaluate proxy initiatives. Just vote the company line.
Second, there is little incentive for index fund managers to advocate for shareholder initiatives, for example, to reign in executive compensation. This is because the index fund automatically earns the return of the index regardless or whether the companies in the index provide good or bad returns to shareholders. The fund manager is measured by only by how well they mirror the index, not by how well the companies in the index perform.
This is why John Bogle advocated adding a legal fiduciary responsibility to fund managers. If they always passively vote with company managers, they might be subject to lawsuits of ignoring their fiduciary responsibilities.
posted by JackFlash at 6:41 PM on February 21, 2019 [9 favorites]
It's important to remember that index funds tracking the same underlying properties will compete first and foremost on their efficiency in that tracking. Funds that put a lot of effort into engaging the underlying assets are wasting their expense ratios.
As far as the dead weight loss, there are plenty of industry-specific funds which wouldn't have that excuse. However, if you were managing vanguard s&p 500 index fund, then the overall benefit to your investors is best achieved (in order of decreasing magnitude) by changes to corporate governance that 1. Decrease waste 2. Increase overall economic growth (with some finesse about us versus oecd vs global) 3. Decrease labor share of income. While those directives wouldn't favor monopolistic lack of price competition, they would favor lack of wage competition. They would also abolish zero-sum taste making exercises like Bud light vs. Miller lite super bowl advertisements.
posted by a robot made out of meat at 7:24 PM on February 21, 2019
As far as the dead weight loss, there are plenty of industry-specific funds which wouldn't have that excuse. However, if you were managing vanguard s&p 500 index fund, then the overall benefit to your investors is best achieved (in order of decreasing magnitude) by changes to corporate governance that 1. Decrease waste 2. Increase overall economic growth (with some finesse about us versus oecd vs global) 3. Decrease labor share of income. While those directives wouldn't favor monopolistic lack of price competition, they would favor lack of wage competition. They would also abolish zero-sum taste making exercises like Bud light vs. Miller lite super bowl advertisements.
posted by a robot made out of meat at 7:24 PM on February 21, 2019
these concerns seem... disingenuous at best. how can you really take all the factors that make big US corporations nonresponsive to consumers, lazy, and sclerotic, and attribute it instead to index funds, of all things?
i mean, for starters, there's the trend toward monopoly and consolidation in many industries due to the toothlessness of antitrust for decades preceding the popularity of index funds, as well as consolidation in new tech industries that regulators seemingly don't know how to deal with at all.
then there's the persistently low effective corporate tax rate (and, since last year, the actually low rate) which coincided with a heightened emphasis on short term profits among execs, which led to risk-averse behavior in management, favoring spending profits on dividends and stock buybacks versus actually, you know, investing in or improving the business. not to mention the outrageous increase in CEO pay since the 1970s, which again incentivizes risk-aversion and hoarding versus investment, to protect the boss's hide.
and of course let's not forget the decimation of private sector unions, widespread use of independent consultant, just-in-time, and contract labor, and increased emphasis on a smaller and smaller cadre of highly skilled workers who are debt-laden with advanced degrees, which increases worker desperation and puts downward pressure on wages for almost everyone and frees up yet more $$ for dividends and buybacks.
amidst all this other stuff, the big concern is... index funds? really? passive investors who, sure, own a chunk of many competing businesses but don't actually directly weigh in on business decisions? and whose owners are perhaps the only significant chunk left of middle class people with investments in the stock market-- and who the ultra-rich hate because they can't fleece them with money manager fees or scam with fly-by-night stocks?
i'm sorry if this all sounds a bit rich, pun intended.
posted by wibari at 11:39 PM on February 21, 2019 [2 favorites]
i mean, for starters, there's the trend toward monopoly and consolidation in many industries due to the toothlessness of antitrust for decades preceding the popularity of index funds, as well as consolidation in new tech industries that regulators seemingly don't know how to deal with at all.
then there's the persistently low effective corporate tax rate (and, since last year, the actually low rate) which coincided with a heightened emphasis on short term profits among execs, which led to risk-averse behavior in management, favoring spending profits on dividends and stock buybacks versus actually, you know, investing in or improving the business. not to mention the outrageous increase in CEO pay since the 1970s, which again incentivizes risk-aversion and hoarding versus investment, to protect the boss's hide.
and of course let's not forget the decimation of private sector unions, widespread use of independent consultant, just-in-time, and contract labor, and increased emphasis on a smaller and smaller cadre of highly skilled workers who are debt-laden with advanced degrees, which increases worker desperation and puts downward pressure on wages for almost everyone and frees up yet more $$ for dividends and buybacks.
amidst all this other stuff, the big concern is... index funds? really? passive investors who, sure, own a chunk of many competing businesses but don't actually directly weigh in on business decisions? and whose owners are perhaps the only significant chunk left of middle class people with investments in the stock market-- and who the ultra-rich hate because they can't fleece them with money manager fees or scam with fly-by-night stocks?
i'm sorry if this all sounds a bit rich, pun intended.
posted by wibari at 11:39 PM on February 21, 2019 [2 favorites]
Why do index fund managers always vote with management? Well, first of all, it's easy. You don't have to think or evaluate proxy initiatives. Just vote the company line.
Because most proxy initiatives are essentially fake votes, and that voting against them just retains the status quo (can be good or bad), it doesn't at all imply that board will become more consumer friendly or less so. If mutual fund boards start voting against the wishes of the corporation, it's just as likely that less stuff will be put to proxy vote.
To put it another way, corporate proxy voting is more like voting for your high school class president than the US president.
posted by The_Vegetables at 7:19 AM on February 22, 2019
Because most proxy initiatives are essentially fake votes, and that voting against them just retains the status quo (can be good or bad), it doesn't at all imply that board will become more consumer friendly or less so. If mutual fund boards start voting against the wishes of the corporation, it's just as likely that less stuff will be put to proxy vote.
To put it another way, corporate proxy voting is more like voting for your high school class president than the US president.
posted by The_Vegetables at 7:19 AM on February 22, 2019
Because most proxy initiatives are essentially fake votes, and that voting against them just retains the status quo
The most common and important proxy vote is the election of board members. Members of the board are supposed to hire and fire the executives. Most commonly the CEO picks the board members rather than the other way around because shareholders just vote the company line, which is the CEO's line. This is a giant failure in corporate governance.
Being a board member is the ultimate cushy job. You get $200,000 a year just to meet four days a year or so, all expenses paid, and all you have to do is exactly what the CEO tells you to do, including giving the CEO millions a year in compensation. The CEO nominates nice compliant board members and lazy shareholders vote for the nominees. The result is looting of company income for the benefit of the executives.
posted by JackFlash at 8:16 AM on February 22, 2019 [2 favorites]
The most common and important proxy vote is the election of board members. Members of the board are supposed to hire and fire the executives. Most commonly the CEO picks the board members rather than the other way around because shareholders just vote the company line, which is the CEO's line. This is a giant failure in corporate governance.
Being a board member is the ultimate cushy job. You get $200,000 a year just to meet four days a year or so, all expenses paid, and all you have to do is exactly what the CEO tells you to do, including giving the CEO millions a year in compensation. The CEO nominates nice compliant board members and lazy shareholders vote for the nominees. The result is looting of company income for the benefit of the executives.
posted by JackFlash at 8:16 AM on February 22, 2019 [2 favorites]
I agree that weak corporate governance (executive looting in particular) is a problem, but it's a problem that should be self-limiting: companies that are managed that way should be less competitive vs. companies where more profits are re-invested in the business. Executive compensation is essentially a deadweight loss on the firm, if it's not getting them better leadership in proportion to the compensation (lol).
What's worth thinking about—and where, personally, I think the problem lies—is why the whole system doesn't seem to self-correct. And I don't think that is due to index funds. It's due to a more widespread and pernicious kind of market failure, where companies are able to suppress competition and build "moats", allowing them to operate poorly and not be punished for it.
"Mergers and acquisitions disease" is another symptom: it's widely understood that many mergers, especially "mega-mergers" between large companies in the same industry, are often destructive of value. But yet they still happen (even financially questionable ones) all the time. This is not something that you would probably predict if you were a bunch of aliens trying to wargame how the market economy works, a priori.
Bogle's suggestion of creating a fiduciary duty for fund managers, which would nudge them towards a more active role on behalf of the ownership interests they manage, is a start (and frankly seems like a bit of a no-brainer). Nothing wrong with that, and it probably would help some of the really dumbass executive compensation stuff that goes on, as a result of board capture by management.
But the real problem is that the market isn't (in many cases) self-correcting in the way that it should be, and I think it's because markets dominated by a small number of very large players aren't competitive at all. The idea that several large companies produce competitive-market outcomes of the type we're led to expect in Economics 101 (where price approaches COGS), is a total fantasy. To produce anything like that, you need a broad, diverse market of relatively small players, with reasonable entry and exit costs. When you have that, you almost always tend to have efficient pricing; when you don't... you don't. (There are certainly exceptions on both ends.) This isn't a really novel analysis or anything, I'm sure lots of economists have noticed it, but regulators have seemingly ignored it wherever possible, preferring to believe the fiction that as long as you don't have a single horizontal monopoly within an industry—as long as there's the barest fig-leaf that could plausibly be called competition—that everything is fine and no intervention is necessary. (See: broadband in the US.)
If you could get regulators who were less reluctant to exercise their powers, and in particular if you let regulators be guided by whether a market was producing efficient outcomes (i.e. "are prices tending towards costs over time?" rather than "is the market dominated by X many companies"), I think you'd see a lot of problems—executive over-compensation, destructive vanity M&As, dangerous grow-or-die bets—become less common. Because none of those things are stuff you'd expect to see in a rational, efficient market. So rather than try to treat every symptom of malfunctioning markets, fix the market.
posted by Kadin2048 at 12:11 PM on February 22, 2019 [2 favorites]
What's worth thinking about—and where, personally, I think the problem lies—is why the whole system doesn't seem to self-correct. And I don't think that is due to index funds. It's due to a more widespread and pernicious kind of market failure, where companies are able to suppress competition and build "moats", allowing them to operate poorly and not be punished for it.
"Mergers and acquisitions disease" is another symptom: it's widely understood that many mergers, especially "mega-mergers" between large companies in the same industry, are often destructive of value. But yet they still happen (even financially questionable ones) all the time. This is not something that you would probably predict if you were a bunch of aliens trying to wargame how the market economy works, a priori.
Bogle's suggestion of creating a fiduciary duty for fund managers, which would nudge them towards a more active role on behalf of the ownership interests they manage, is a start (and frankly seems like a bit of a no-brainer). Nothing wrong with that, and it probably would help some of the really dumbass executive compensation stuff that goes on, as a result of board capture by management.
But the real problem is that the market isn't (in many cases) self-correcting in the way that it should be, and I think it's because markets dominated by a small number of very large players aren't competitive at all. The idea that several large companies produce competitive-market outcomes of the type we're led to expect in Economics 101 (where price approaches COGS), is a total fantasy. To produce anything like that, you need a broad, diverse market of relatively small players, with reasonable entry and exit costs. When you have that, you almost always tend to have efficient pricing; when you don't... you don't. (There are certainly exceptions on both ends.) This isn't a really novel analysis or anything, I'm sure lots of economists have noticed it, but regulators have seemingly ignored it wherever possible, preferring to believe the fiction that as long as you don't have a single horizontal monopoly within an industry—as long as there's the barest fig-leaf that could plausibly be called competition—that everything is fine and no intervention is necessary. (See: broadband in the US.)
If you could get regulators who were less reluctant to exercise their powers, and in particular if you let regulators be guided by whether a market was producing efficient outcomes (i.e. "are prices tending towards costs over time?" rather than "is the market dominated by X many companies"), I think you'd see a lot of problems—executive over-compensation, destructive vanity M&As, dangerous grow-or-die bets—become less common. Because none of those things are stuff you'd expect to see in a rational, efficient market. So rather than try to treat every symptom of malfunctioning markets, fix the market.
posted by Kadin2048 at 12:11 PM on February 22, 2019 [2 favorites]
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c.f. Index Funds Are A Proof Of Concept For Market Socialism (previously)
posted by the man of twists and turns at 12:36 PM on February 21, 2019 [2 favorites]