There’s a paper doing the rounds at the moment that’s causing quite a stir. It’s by Inigo Fraser-Jenkins from the investment research firm Sanford C Bernstein, and it carries the rather provocative title The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism.
The paper does not say that passive investing is a bad idea, but it does raise important questions about how beneficial (or otherwise) the shift to passive investing is for society as a whole. This is a very big issue — too big to deal with properly in a single post — but let’s try to put this in some sort of context.
Active still dominates
Fraser-Jenkins, and others before him, have expressed concern about passive funds dominating the asset management industry. Realistically, though, that scenario is a long way off. Yes, there’s been a huge shift towards passively managed mutual funds and ETFs in the US over the last year or so, but even there, passive funds still account for only a modest proportion of total investable assets. Almost everywhere else in the world — including the UK, where I’m based — indexing has barely scratched the surface. It’s taken more than 40 years for passive to reach the point it has in the States, and it won’t achieve worldwide domination overnight.
Active will never die
Contrary to the impression given in the Bernstein paper, there will always be active investors. It’s human nature to think that the market can be beaten, and there will never be a shortage of fund managers willing to take money off people who want to give it a try. Even if, hypothetically, we reached a situation where almost everybody indexed, it wouldn’t stay that way for long. To quote Sam Bowman at the Adam Smith Institute, “if passive investments became inefficient, that inefficiency would create an incentive to become an active investor”. In those circumstances, heck, I would certainly be one of them. But seriously, folks, it’s never going to happen.
New offerings account for a tiny fraction of active trading
Another argument that Bernstein uses, and one we’re hearing more and more, is that its active managers who drive economic growth by allocating capital to the entrepreneurs who need and deserve it most. Again, this is largely a fallacy. For a start, they frequently misallocate funds, as demonstrated by the high percentage of heavily hyped start-ups that fail. But, more importantly, new offerings account for a tiny fraction of trading — Jack Bogle has estimated around 1%, which means that 99% of market activity is simply active traders trading with one another.
Passive shareholders are just as effective as active
What about the suggestion by the likes of Fraser-Jenkins that passive investors don’t make good shareholders? Surely the system depends on investment funds (which in practice are the largest shareholders) holding company boards to account? Again, it sounds a logical argument but ultimately falls flat. In fact, active managers often make bad shareholders; the repeated failure to vote against excessive pay deals for senior directors is a prime example. A recent study by Cass Business School and the University of Toulouse revealed how an “old boy network” among fund managers is preventing companies from voting against rivals’ boards at annual meetings. Meanwhile, research in the US has shown how the growth of indexing is actually having a positive impact on corporate governance.
Passive investing raises standards
Capitalism thrives on competition, and one of the benefits of competition is an improvement in the quality of goods and services. Why, then, should proponents of active management object to the growth of passive? As Craig Lazzara at S&P Dow Jones has pointed out, the question to ask is, Where does the money currently flowing into passively managed funds come from? “If you believe that some active managers are more skilful than others, and that their skill is manifested in outperformance,” says Lazzara, “then presumably it must be the least skilful active managers who lose the most assets. In that case, the existence of a passive alternative raises the quality of the surviving active managers.”
Passive investing drives down prices
Of course, the other main benefit of increased competition is cheaper prices. Fees and charges are, slowly, starting to fall, particularly in the US. A recent study by Morningstar concluded that lower costs are principally explained by “large inflows to Vanguard’s low-cost passive funds”. How can you say the growth of indexing is undermining capitalism when its single biggest impact has been to lower the cost of investing for tens of millions of investors around the world?
The longer a debate goes on, the more likely people are to resort to extreme arguments, and the “indexing is worse than Marxism” thesis surely falls into that category. The irony of an industry that has effectively imposed a stealth tax of individuals and companies for decades now presenting itself as the bastion of a vibrant economy is quite extraordinary. In allowing ordinary people to keep a bigger share of their investment returns for themselves, passive investing is serving a far, far greater social and economic purpose than professional stockpicking ever will.