John Bogle, the original pioneer of index funds, never imagined his creation could become a monster. For decades, exchange-traded funds were niche products, overshadowed by actively managed mutual funds and hedge funds. But in the past couple decades, things have changed completely. The value of index funds’ long-term performance was already gaining widespread appreciation in the first decade of the 21st century, but the financial crisis and subsequent Great Recession really got the ball rolling for the index funds.
When the active managers were exposed to have feet of clay, many investors began to put their faith in the market return, and to hell with trying to squeeze alpha out of the stock market. Today, index funds are massive. Vanguard, the asset manager Bogle founded and built, now manages $5 trillion on its own.
One would think that these developments would be gratifying to a man who was once laughed at for the the idea of selling a product aimed purely at replicating the market return, or some component thereof. In truth, however, Bogle is not happy. He is worried.
More to fear than a passive bubble
Bogle has sounded off about the damage that could be done thanks to the proliferation of exchange traded index funds (ETFs) as opposed to privately managed index funds. Indeed, we discussed his concerns about ETFs in a previous research note. In that note, we discussed Bogle’s growing concern that the huge amount of capital now in passive funds has made the market inefficient and liable to create serious fluctuations thanks to their growing use as speculative instruments:
“Bogle has made his distaste for ETFs quite clear over the years, but in recent months he has ratcheted up the vitriol. He has described them as speculative instruments that have ‘bastardized’ his idea of the index mutual fund.
“The accusation of speculation comes from the observation that turnover within ETFs tends to be far higher than the turnover in individual stocks. While the hundred largest stocks see turnover of about 144%, the hundred largest ETFs see a staggering 785% turnover. Much of this turnover is the product of institutional, rather than individual trader, behavior, but it is still indicative of speculative action that might run contrary to the very idea of an index fund, i.e., it tracks the index in relative lockstep.”
But the problem goes much deeper than this, according to Bogle. While ETFs may have robbed index funds of their power to garner the market return over the long-term in lieu of accepting inadequate (and often ineffective) active management, the wild expansion of the size of index funds in the economy may hold even worse surprises.
Competition fades away
The latest danger Bogle foresees comes from a worrying degree of concentration among the asset managers running index funds. Writing in The Wall Street Journal on Nov. 29, Bogle discussed the growing dominance of a few big players in index funds:
“Three index fund managers dominate the field with a collective 81% share of index fund assets: Vanguard has a 51% share; BlackRock, 21%; and State Street Global, 9%.”
It is interesting that Bogle would call out his own creation so directly. But Vanguard has been such a dominant player in the index fund game, he cannot ignore it. Bogle has a clear assessment of why this concentration is happening, and it does not bode well:
“Why? Partly because of two high barriers to entry: the huge scale enjoyed by the big indexers would be difficult to replicate by new entrants; and index fund prices (their expense ratios, or fees) have been driven to commodity-like levels, even to zero. If Fidelity’s 2018 offering of two zero-cost index funds has established a new price point for index funds, the enthusiasm of additional firms to create new index funds will diminish even further. So we can’t rely on new competitors to reduce today’s concentration.”
With the ability for huge players like Fidelity to cut the cost of index fund purchases virtually to zero, there is little hope of a smaller or nimbler player getting in. In this way, the biggest index fund players have built an almost unassailable moat. Unsurprisingly, Bogle does not see that as a good thing.
Passive power grows
At the end of September, 17.2% of all equities in the Wilshire 5000 index were owned by index funds, nearly double their share of ownership of just a decade ago. It is even more staggering when one considers that index funds accounted for a meager 2.3% of the Wilshire 5000 in 1998 -- a mere two decades ago.
Bogle sees this trend continuing and has worries that transcend the obvious issues being created by the evident passive investing bubble now in action. As Bogle wrote, another real risk is that a tiny number of agents will have unprecedented control of the nation’s financial markets:
“Most observers expect that the share of corporate ownership by index funds will continue to grow over the next decade. It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the 'Big Three' might own 30% or more of the U.S. stock market - effective control. I do not believe that such concentration would serve the national interest.”
This vision could play out in precious few years, and it is indeed worrying. While these asset managers are passive insofar as their investments mimic the behavior of the underlying assets, the companies holding the stocks do usually have voting power. That gives these few agents remarkable sway in the corporate governance of a huge swath of America’s business world. The potential risks inherent in such power have rarely been considered. But they really should be.
Verdict
Bogle is a true financial visionary. He staked his reputation and career on the idea of the index fund and, while it took decades to be proven right, he was ultimately vindicated. So it is worth listening when he says there are scary issues emerging from his creation.
Index funds have taken on a life of their own and, while a fair number of analysts have woken up to the risks posed by a potential passive bubble, fewer have given a thought to the ramifications it could have on empowering a few agents to dominate the markets.
The remedy to this problem is far from clear. Political will in the U.S. tends to be limited when it comes to this sort of thing. And what level of restriction would even be possible? These are issues that have received -- at best -- passing attention from practitioners, academics and policymakers. They need to wake up quickly to our strange and frightening reality.
There is no guidebook to the current capital market. Index funds are essentially new beasts, at least at scale. Investors should watch very carefully in the next couple years. They could prove decisive to the stability of capital markets.
Disclosures: No positions.
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