Renaud de Planta argues that if the majority of investors embrace index funds, they are likely to lead to less efficient markets and weaker corporate governance.
To its growing band of proponents, passive investing is looked on as a panacea. Equity tracker funds, we’re told, will rid the financial market of toxic elements and restore it to full health.
At first glance, it’s a persuasive argument. Poorly performing and expensive active managers have lingered in the system for too long, eroding returns for investors. Yet on deeper reflection, index-tracking products are no miracle remedy. They’re more like antibiotics: valuable when deployed in moderation, but likely to do more harm than good should their use become widespread.
If passive equity funds, which already collectively own close to 50 per cent of US large-cap companies, were to continue their present growth trajectory, they would own all listed stocks by 2030. That could undermine the free-market economy.
Under index-tracking, the shares of companies with large weightings in the major indices attract more capital irrespective of their underlying performance. So in a system in which passive funds monopolise investment flows, the price of a security ceases to function as a gauge of a firm’s underlying prospects. This distorts the cost of equity and the price of credit, creating asset bubbles on the one hand and leaving innovative firms starved of funds on the other.
And what happens when a small group of passive shareholders — who can’t vote with their feet — control most or all of the companies in a given industry? A weakening of corporate governance standards and an erosion of competitive forces.
Worse still is the concentration in the passive fund market. Essentially, the industry is an oligopoly, with just three asset management giants controlling almost three-quarters of all passively-managed investment in stocks. And the more assets they gather, the more they can reduce fees and so continue their expansion, in contrast to active managers, whose room for manoeuvre is constrained by liquidity and therefore size.
There are other implications. Effectively able to influence or even decide which country or company should be included or excluded from (those) benchmarks, they would wield enormous influence over international capital flows. Some might see that as an excessive concentration of power.
Passive dominance won’t happen overnight. Yet, left unchecked, the growth of index-trackers has the potential to erode the market-based economy, one industry at a time.
None of this relieves the pressure on active managers to perform and offer better value to their clients. Nor does it deny the utility and benefits of passive investment to investors. The problem is that if the majority of us embrace index-trackers, they threaten to sabotage the entire economic system on which free markets and competition depend. Like even the most benign of drug remedies, passive funds, if overused, will create more problems than they solve.
Renaud de Planta is Managing Partner of the Pictet Group and Chairman of Pictet Asset Management