Warnings for Index Fund Investors?

On Point, a broadcast heard on National Public Radio (NPR), had a program this week titled “Are Index Funds Getting Too Powerful?”  The title lured me in to listen because it is a subject to which I’ve given some thought as I contemplate moving some investments around.  But I was a bit careless.  My concern has not been about index funds being too powerful but, rather, too concentrated.  But both might be legitimate worries that affect a great many investors, likely including you.  I enjoyed the broadcast.  So let’s look at both potential dangers.

First, I should give a brief background on index funds.  John Bogle, the founder of Vanguard and considered the father of index funds, launched his enterprise in 1975.  His premise was that mutual fund managers who tried to outperform the general market through savvy selection of stocks were, over time, doomed to fail.  He instead promoted owning the “whole market” by creating mutual funds that held shares of all the companies contained in a certain index.  The S&P 500 (an index that tracks the nation’s largest 500 publicly owned companies) is considered the prime example.  So rather than employ researchers and analysts to select the investments likeliest to increase the most in value, he simply created mutual funds that bought them all, counted on the generally upward movement of the stock market to propel investment returns, and charged a much lower fee to investors since he didn’t have to pay elite stock-pickers—who, again, he believed would fail to outperform the market anyway.

So the low-cost index fund has become a go-to investment for those not wanting to worry about picking the right stocks or paying others to do so.  But my concern is that this is pushing too much money into a smaller group of companies.  For instance, mutual funds tracking the S&P 500 index are typically based on market capitalization.  That means the shares of the most valuable companies (the most “highly capitalized”) dominate the holdings.  (There are mutual funds that buy shares on an equal basis across companies rather than by capitalization.)  In fact, I’ve read statistics that show the five largest companies in the S&P 500 (that’s 1% of the companies in the index) currently represent about 23% of its value.  And as you might guess, these are tech companies (Apple, Microsoft, Google, Amazon, and Nvidia).  And that’s fine….when the tech sector is booming.  And it has been booming, and therefore driving some good returns for investors in S&P 500 index funds.  But what happens when the tech sector goes sour?  The whole idea of a mutual fund is to diversify your portfolio—across companies, across sectors of the market, across industries.  Is that truly happening now with any index funds tracking that index?  And is it good or bad for investors?  I’ve read pros and cons on this.  (It seems the “experts” can never agree on anything!)  But if you are one who is invested in an S&P fund, it might be worth some thought as to whether you should make any changes to your portfolio.

Now as to the other concern, the “too powerful” argument, that was applied by the guest speaker on On Point, John Coates, to the mutual fund companies themselves.  Coates, a professor of law and economics at Harvard University and a former executive in the Securities and Exchange Commission, sees the big fund companies (which he identified as Black Rock, Vanguard, State Street, and Fidelity) holding 20+% of the shares of publicly owned companies and therefore as shareholders able to exert a concentrated, outsized influence on those companies’ decisions relative to selection of board members, deciding company policies, and votes on resolutions coming before shareholders.

Again, this may or may not be a problem.  It depends on whether those funds exert a benign influence.  And that determination tends to be very subjective, even political.  As a former regulator, Professor Coates proposes that these fund companies offer their clients (investors who have entrusted their money to them) an opportunity to express their policy preferences through surveys, offering “families or groups of values” from which clients select.  Of course, it’s an imperfect proposal, and there will not be unanimity among those clients, but it would give the fund companies some indication of their preferences; and since the fund companies can split their vote (i.e. vote a portion of their shares one way and another portion another way) they might actually approach some level of democracy in the voting process on the nearly 3500 proposals voted on by the companies each year.

A lot to chew on, I know.  It gets complicated.  But I thought it worthy of a post here.  Next time you get a notice from your investment firm wanting to know how to “vote your shares” or asking you to “designate X as a proxy for you” in a shareholders’ meeting, think about all this.

Until next time,

Roger

“Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.” Ecclesiastes 11:2 NIV*

*Scripture quotations taken from the Holy Bible, New International Version® NIV® Copyright © 1973, 1978, 1984, 2011 by Biblica, Inc.™ Used by permission.  All rights reserved worldwide.