In order to address the impacts that index investing has had on current stock market ownership, one must understand the history of this type of passive investing. John C (Jack) Bogel is known as the father of Index Investing”. Bogle founded Vanguard Group in 1974 and started the First Index Investment Trust on December 31, 1975. It was devised as a way for individual investors to be able to compete with the professional stock traders. It was later renamed the Vanguard 500 Index. The fund was set up with the idea to invest in 100 share lots in every company in the Standards and Poor 500 (S&P 500) and to approach these investments with a long-term focus. Bogle envisioned a fund that would approximate the returns of the overall market while minimizing expenses associated with frequent trading.
Growth of Index Funds
Growth was slow in the beginning and the initial capitalization only allowed the fund to invest in 280 companies. The fund failed to beat the average of other funds which were actively managed. It took a while for the index funds to catch on. Over the last few decades, there has been tremendous growth. These passively managed funds now hold nearly $7 trillion in assets and are catching up to the $11 trillion in active strategies (Cox, 2019).
The First Index Investment Trust was a mutual fund, which prices at the end of the day and cannot be traded during normal market hours. These passive investments have evolved over time to include exchange-traded funds (ETF). They still track indexes and carry much lower fees than most mutual funds. A key difference is that investors are now able to trade them through the day, subjecting them to the intermarket moves and manipulation by professional investors. Additionally, theses ETFs are often indexed to specific industries or narrow group of companies decreasing the diversification that is key to safety of the index funds. Currently, almost half of all passive investment funds are ETFs.
Criticism of Index Funds
The S&P 500 index fund failed at first to beat the average of the active funds. Critics were harsh, calling it “Bogle’s folly” and even asserting that index funds were un-American. Fidelity’s chairman, Edward C. Johnson III, famously said investors would not be satisfied with average returns. Even after merging another fund into the 500 index fund, Vanguard failed to attract much investor capital. (Roth, 2019)
Consolidated Stock Ownership
As a result of the growth of these funds, passive funds now own an average of 17% of each component of the S&P 500, per Goldman’s data. Vanguard itself owns over 5% of the stock in 468 of the 500 components of the S&P 500.
While the growth in the popularity of passive index funds has been positive for individual investors, it has not been as positive for the companies. The consolidation of ownership among the top passive index funds has increased the opportunity for activists to force changes in corporate board ownership. Studies show that the activists have greater success by activists in obtaining board representation, removing takeover defenses, and facilitating the sale of a targeted company.
As a result of the increase in fund ownership, as much as 40% of all traded shares are traded for reasons other than underlying business fundamentals. Trades are often the result of rebalancing within the fund. This can result in more volatility in stock prices and an increase in the ability to manipulate stock prices. Long-term, this could have the effect of reducing the effectiveness for index funds to minimize risks and expenses while maintaining returns in line with the market it is following,
References
Appel, I. A., Gormley, T. A., Keim, D. B. (2018). Standing on the shoulders of giants: The effect of passive investors on activism, The Review of Financial Studies, hhy106, https://doi.org/10.1093/rfs/hhy106
Bogel, John C. (2007). The little book of common sense investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns. Macmillan Audio
Brogaard, J., Ringgenberg, M., & Sovich, D. (2018). The economic impact of index investing. The Review of Financial Studies. https://doi.org/10.1093/rfs/hhy129
Cox, J. (2019, January 16) Jack Bogle changed investing forever with index funds, but wasn’t always happy about it. Retrieved from https://www.cnbc.com
Roth, A (2019, January 16). What I, and millions of others, owe Jack Bogle. Retrieved from https://www.financial-planning.com
Valastica, R (2017, September 27) Passive investing is changing the stock market in ways investors don’t realize. [Web log post] Retrieved from https://www.marketwatch.com