Morningstar Magazine - October/November 2017 - 13

This line of attack, unlike the previous two,
comes from academia, meaning that it
has the advantage of being less biased, but the
disadvantage of being more obscure.
The criticism that index funds fail with corporate
governance is long-standing, but its details
have changed. Historically, index funds were
accused of neglecting proxy statements,
which, critics said, cost profits and lowered
shareholder values. This argument had the support
of both Wall Street and finance professors.
Until quite recently, the consensus was that
if left unchecked, CEOs would sacrifice profitability
in order to build empires. The bigger their
companies, the more important that made them.
Their employees would also be happy, because
the company would be adding jobs. So,
the task of outside shareholders was to nag,
nag, nag, so that the company would divest,
divest, divest.
Naturally, active portfolio managers agreed,
as this thesis portrayed them as the unsung heroes
of the stock market. They might be loud, they
might be annoying, and they might charge high
fees for their services, but they were on the
side of the angels. Their individual, selfish acts
worked to the benefit of investors everywhere.
That theory had a major problem. According
to its underlying logic, CEOs would get
progressively worse at their jobs as index funds
became larger, because the companies
would increasingly be owned by shareholders
who would not sell their stock no matter
how badly the company behaved. Thus, corporate
profit margins would decrease further, along
with shareholder value.
So much for that prediction. Each year, U.S.
corporate profits exceed last year's mark. The
challenge has become not to explain why
CEOs underperform and how they can do better,
but rather to explain why they have been so
very successful. In fact, states the latest academic
argument, CEOs have been too successful.

The claim goes like this: Because index-fund
managements haven't pushed CEOs to attack their
rivals more aggressively, CEOs behave as
if they are in cartels. Why fight other companies
when all sides can benefit by playing nicely?
Thus, corporate managements have not
emphasized growing their slice of the industry pie,
but rather making the whole pie larger, through
semimonopolistic behavior.

But activist funds are rare indeed. Actively
managed mutual funds behave much more like
index funds. Midsize to large fund companies
own thousands of stock positions. They have
neither the time nor motivation to hound all those
corporate managements, or even more than
a tiny fraction of them. Whichever way index funds
end up voting their proxies, so too will most
actively run mutual funds.

In this tale, index funds remain the bad
guys, but now they are to be blamed for increasing
share prices. Because of the inactions of
index funds, corporations are not competing
vigorously enough, which enables them
to overcharge, which boosts their profit margins
and share prices-but at a social cost.
Consumers are paying too much for the goods
and services they consume.

The same precept holds for the stock market's
other major parties. The giant pension
funds have huge, diffuse portfolios, as do
sovereign-wealth funds. Perhaps some
of the underlying managers that they hire are
activist, but the funds themselves are not.
(They may lobby companies for social changes,
for example to implement green policies,
but that is a different matter.)

Martin Schmalz, assistant professor at the
University of Michigan, explains:

And that brings us to ... retail investors who own
equities directly. I am in that crowd, holding
a few stocks along with my core mutual funds.
I confess to never having read through any proxy
statement that I have received from a company, or indeed voting on any action. Perhaps I am
radically different than the norm, but I doubt it.

"The whole trick of common ownership is that you
need no collusion for higher prices to obtain,
because common ownership reduces the incentives
to compete in the first place. The reason is that
competing less aggressively can be in the unilateral
interest of each firm in isolation. When the
most important shareholders have reduced interests
in their firms competing, why would the firms
still compete?" 2
Let's assume that the latest academic
hypothesis is the correct one. Are index funds
to blame? I don't see how. After all, nearly
all forms of investment management lead to giving
CEOs great freedom. True, "activist" portfolio
managers seek seats on boards, badger
corporations to divest themselves of subsidiaries,
and may even insist a firm put itself up
for sale. Index funds rarely take such extreme
actions-though Vanguard's Investment
Stewardship group provides extensive examples
of corporate engagement and proxy voting
in its 2017 annual report, belying the
accusation that index funds are indifferent
to corporate governance.

The new hypothesis that professional investment
managers have permitted U.S. businesses
to engage in semimonopolistic prices is intriguing.
Perhaps it will eventually be accepted. Even
if so, it's difficult to see how index funds are at
fault. If they had never been born, so that the
leading stock mutual funds today were diversified
offerings from American Funds and Fidelity
and T. Rowe Price, corporate governance would
likely be similar. And the academic community
would be raising the same questions about
whether CEOs have overstepped their bounds.
Verdict on Count Three: Not guilty.
Whatever sins index funds have committed, they
have been joined while doing so by many,
many others. K
John Rekenthaler is vice president of research
with Morningstar Research Services.

2 Rolnik, G., & Schechter, A. 2016. "The Anti-Competitive Effects of Common Ownership: Q&A with Martin Schmalz." Pro-Market, Dec. 16. https://promarket.org/threats-competition-common-ownership-asset-managers-qa-martin-schmalz/

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Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2017