Are Index Funds Really “Eating the World”?

Index Funds

Morningstar just hosted a conference entitled “Are Index Funds Eating the World”? Some people are worried that index funds may be making everything more expensive.

We all know that index funds are growing at a very fast rate, and are now on the brink of overtaking actively managed funds in terms of the percentage of money that that people put into these two types of mutual funds. This trend has alarmed some people for some time now, and the phrase “eating the world” has been around for a few years now actually.

These concerns have been more general, as in it just can’t be good to have so few big fund companies, but are now being extended to claims that index funds may be or already are putting the price of everything up, as well as notions that index funds may run counter to capitalism. Some even go as far as to say that index funds are worse than capitalism, where capitalism is held to be in disrepute and index funds somehow surpasses this level of undesirability.

While there is little doubt that index funds growing this much does have some effect upon the stock market, as this does provide broader market moves, these new claims appear to be simply outrageous, on the surface at least. We therefore owe it to ourselves to examine the criticisms and fears that are out there even though they may be on the far side of things, if for no other reason than to dispel them if they do not have any real merit.

The idea behind index funds is to simplify investing, and index funds certainly do that. If you buy units in an index fund, you know exactly what you are getting, so there is total transparency involved here, which is a good thing.

Actively managed funds may not want to be that forthcoming with what they are doing with the funds they manage, and while there is a level of disclosure that they are require to provide, this is not complete, due to concerns of proprietary information being disclosed to competitors.

This is not really a big deal though and not something investors really care about, as they turn their money over to the fund managers and let them do their thing.

The Sheer Simplicity of Index Funds

Managing index funds is so simple, as you just buy all the stocks in the index that the fund is looking to track, and that’s it, and this also reduces management expenses. You don’t have to pay the manager millions of dollars a year to make decisions because there are no decisions to make and the process pretty much becomes automated, which is a real advantage. Management of the fund itself is actually absent, leaving them to focus on things like efficiency and marketing.

You also don’t have to worry about not beating the market anymore, as most funds fail to do, because you are investing in the market itself. When we speak of beating the market or keeping up with it, we refer to a fund’s performance versus major stock indexes such as the S&P 500. If your fund tracks this index, you won’t quite match its returns but you will do so less your expenses, which are very small with this type of fund. There are no arguments or disappointments, because you get what the index gives you, as you expected when you bought the units.

Actively managed funds have the potential to beat index funds, but only about 1 in 5 actually do that, with the other 4 underperforming them. We might then think that while index funds may beat 4 out of 5 active funds, we just can go with the one out of five that beats them, but the problem is that the winners change a lot, and you can’t rely on a fund that beat the market last year to do it again.

It’s not hard to see how index funds have become so popular. In 2010, index funds only represented 25% of all funds under management, but today they are up to 49% and about to pass active funds. At the rate we are going, it may just be a matter of time before actively managed funds may play a small role in the mutual fund landscape, with index funds simply dominating.

It is actually not that easy to imagine how this could be a bad thing, as more efficiency and transparency are far from negatives, and the better returns on average that index funds earn is another desirable trait.

At the Morningstar conference though, panelists debated such things as whether index funds pose a risk to capitalism and whether they cause the price of everything to rise.

These are all jaw-dropping ideas, even to the point where it would even be hard to imagine conspiracists coming up with such radical notions, let alone people who have been invited to speak at a Morningstar conference.

Pointing Fingers at Index Funds

We first need to ask where this might even come from, and as it turns out, it is because index funds are dominated by just three mega fund companies, BlackRock, Vanguard, and State Street. This has concerned the SEC as far as their fearing that having so much of the ETF market so concentrated in just these 3 companies that this might limit competition, which we spoke about not long ago, but these claims go further, much further in fact.

This is evoking visions of the robber barons of the 19th century such as John D. Rockefeller. Rockefeller didn’t even need a partner as he single-handedly controlled the oil business at one time, and there were also many deals between people during that era that clearly was counter to competition.

There has not been any evidence that these three index fund companies are colluding though or have ever done so, and that should put an end to the discussion, but fear is not always rational. Their sheer size scares some people quite a bit, although we do have to look to back all this up with evidence, or at least a reasonable explanation of how they could use their size to cause all the ills that people are afraid of.

The worry boils down to their somehow teaming up with companies that they own stock in to get them to keep prices artificially high. We therefore need two levels of collusion here, the index funds colluding together to influence companies to collude with each other to step away from the free market and competition and get together and fix prices.

This may be even more far out than just about anything that you would see in the conspiracy theory videos, as far out as these views can become. It is at least possible in theory that the U.S. was behind 9/11 or the moon landings were a hoax, or that a table full of people rule the world. The conspiracy with index funds not only lacks reasonableness, it isn’t even fathomable, or at least isn’t when we stop to think of all this.

Some funds to look to influence the companies whose stock they own, called activist funds. They do so to improve the bottom line of the companies though, which involves things like improving efficiency. Encouraging collusion among the companies that they own is not part of this. Activist funds are of course active funds, and they use their leverage, the ability to move out of the stocks if they don’t get their way, as their point of influence.

Passive funds don’t even have this tool though as they are married to all of the stocks in an index and don’t even have the ability to pull out or to favor one stock over another. If we see mutual funds as tigers, this one doesn’t even have any teeth, yet this is the one that these people are worried about.

Funds don’t actually even own stocks, they just manage them, on behalf of their investors, their clients. The only role that index funds play is as in intermediary, taking people’s money and buying a basket of an index for them, and selling their shares in this when requested. It is their boiling the role of a fund down to these very simple elements and no real participation in the returns at all that people find so attractive.

If we think that big companies are colluding to fix prices to make more money, and there is always some of this that goes on out there, it certainly wouldn’t be at the behest of index funds. Just about all big companies compete fiercely with one another and lean on that side of things, where they send out spies to try to get the upper hand on their rivals and use that to try to beat them, not form secret arrangements generally to join forces and make the world pay more for things.

Proponents of this conspiracy are comparing the price of certain things like airfare, comparing timelines with the growth of these index fund companies, and assuming that one is causing the other. That simply does not follow of course.

This isn’t unlike something such as a kid growing taller and thinking that this has caused the price of things to rise. It’s one thing to make the error of assuming causation, but quite another to do it between events that really don’t have a plausible connection.

Even if we only had one index fund company who had a complete monopoly on index funds, the only thing they could really do with this is try to artificially increase their fees, but they could only do that to a degree they could get away with and if this was overdone, the fees with active funds or just investing on your own would restrain this.

This isn’t the case at all though as we have 3 powerful index fund companies duking it out, all being well capable of pushing each other so that this market becomes very efficient indeed. There is nothing really to see here if you are looking for the great demon that makes things cost more, but this is the last place you would ever find such a thing.

Ken Stephens

Chief Editor, MarketReview.com