As an advocate of passive investing, I’ve become a little cynical about all the scare stories surrounding index funds in recent years.
We’ve heard, for instance, that they hinder efficient capital allocation and have a detrimental impact on price discovery. Critics have also suggested that they’re causing a bubble in asset prices, and even that they’re undermining capitalism and are “worse than Marxism”.
None of these claims bear close scrutiny. Indeed they tell us more about the disruption that passive investing is causing to powerful vested interests, and the threat it poses to bonuses, profits and jobs.
It is noticeable too, how the financial media tends to give more attention to negative stories about indexing than it does to positive ones. A good example was the recent release of a paper called Passive Investors, written by Jill Fisch from the University of Pennsylvania, Assaf Hamdani at Tel Aviv University and Steven Davidoff Solomon at the University of California, Berkeley.
The paper, which received very little media interest, looks specifically at the impact of the growing popularity of index funds on corporate governance. The line from many in the fund industry is that passive investing is a threat to governance, and that passive fund managers are somehow less willing or able to hold boards to directors to account than active managers.
In fact, as this new paper points out, the opposite is true. Unlike active managers, who regularly buy and sell stocks, passive managers, by definition, have to be long-term investors. “This creates incentives for passive funds to retain and grow capital,” say the authors, “and to engage actively with firms and other market participants such as activist hedge funds.”
The paper also makes an important distinction between passive managers and passive investors. Some have argued that passive investors are largely indifferent to corporate governance. Whether or not that’s true, Fisch, Hamdani and Solomon point to growing evidence that, at an institutional level, passive funds are increasingly bringing their influence to bear.
The authors note, for example, that BlackRock had more than 1,600 shareholder engagements in 2017, while Vanguard reported more than 800 and State Street more than 600. Such efforts, they argue, were influential in the success of shareholder proposals like the new climate change disclosures adopted by Exxon Mobil last December.
In fact, this isn’t the only recent study to have shown the positive impact that passive fund managers are having on corporate governance. A paper released in May, entitled Institutional Ownership in Financial Services: Performance and Risk, by three academics at St John’s University in New York — James Barrese, David Pooser and Ping Wang — focuses on corporate governance at banks and insurance companies. It shows how ownership by the big three passive managers has resulted in better performance and, consequently, better investment returns.
The findings of these two studies are actually very exciting. What the researchers are saying, in both cases, is that far from weakening corporate governance, the growth of passive investing is actually strengthening it. Not only does this mean that companies are better run; it’s also driving higher returns. That, in turn, is good for all investors, active and passive alike.
And one more thing. Good governance doesn’t just benefit companies and shareholders; it can also be good for the environment and society as a whole. I’ve already referred to the influence that the big passive managers have had at Exxon Mobil. But it’s also worth noting the part being played in tackling climate change by Europe’s largest passive manager, Legal & General Investment Management. The company recently announced that it will vote against reappointing the chairmen of eight multi-national companies in protest at the slow progress they’re making on moving to a greener economy.
So, next time you read about the dangers of indexing, always ask who it is who’s making the claim and why. And remember, there’s another, more positive side to the story that is given far less attention.
ROBIN POWELL is the founder and editor of The Evidence-Based Investor. A freelance journalist, he runs Regis Media, a specialist content marketing consultancy for financial advice firms, and is Head of Client Education for the UK-based financial planning firm RockWealth LLP.