More Money than Most Countries

So-called “index funds” – equity investment funds that simply track a specific US stock market – have trillions and trillions of dollars in assets. Three individual funds, Black Rock, State Street and Vanguard simply dominate that market dramatically. Together, they control about $4.3 trillion in equity assets (out of an entire market of about $11 trillion), with trading volumes a multiple of their assets. Remember the good old days, individual investors would play the stock market, acting on instincts and whatever information that could glean? Day-traders? Online access made it all so easy, and various trading companies were raking in the bucks, charging for every trade.

Then the sophisticated analytics kicked in, programmed trading and even strategic location of the analytical computers to be closer to the exchanges they tracked, nanoseconds faster in getting information and reacting. Before and during this evolution, a parallel and vastly more simple investment vehicle was formed and began to grow. It started out slowly, and frankly, the early years did not produce the results generated today. Index funds.

According to the January 9^th Bloomberg.com: “The surprising thing about all this is that index funds began so modestly. They were a niche product aimed at investors who took the then-radical position that paying close attention to individual companies wasn’t worth the effort and expense. In the decades after [Vanguard founder Jack] Bogle launched the first retail index fund in 1976, that idea would be proven right again and again. For example, only 10% of actively managed U.S. large-cap funds outperformed the market in the 15 years through June 2019, according to S&P Dow Jones Indices data.

“Investors caught on, and money piled in. Vanguard, now led by CEO Mortimer ‘Tim’ Buckley, boasts more than 30 million investors globally. The original Vanguard 500 Index fund now has about $405 billion in assets; there are about 380 U.S. mutual funds that follow indexes. Add to this list exchange-traded funds [ETFs] that track indexes and can be bought and sold instantly just like stocks. In 1993, State Street’s investment management arm, State Street Global Advisors, launched the first of these in the U.S., the SPDR S&P 500 ETF Trust, or SPY for short. BlackRock got into the business when it acquired iShares in 2009 from Barclays Plc. The U.S. now has more than 1,400 equity index ETFs. In August 2019 the industry reached a milestone when the $4.27 trillion in passively managed U.S. stock funds outflanked the $4.25 trillion run by stockpickers. According to the ICI and Morningstar, last year assets in index funds globally climbed above $11 trillion.

“The Big Three represent the key votes on matters such as mergers and shareholder activist campaigns. The fund companies also hold what they call ‘engagements’ with companies through meetings and phone calls. But perhaps unsurprisingly, because the rise of index funds is relatively new, academics who study common ownership have different ideas about how the fund managers’ influence might be felt. Some, such as [Harvard Professor John] Coates, think they could emerge as key power players, perhaps joining their votes with hedge funds that push for deals or corporate restructurings. Such deals can boost share prices but may also lead to layoffs…

“Their success has had a weird and unintended consequence. As millions of investors have done the most sensible thing financially, they’ve also concentrated shareholder power in the Big Three. Some 22% of the shares of the typical S&P 500 company sits in their portfolios, up from 13.5% in 2008. Their power is probably greater, given that many stockholders don’t bother to vote their shares.

“BlackRock, Vanguard, and State Street combined own 18% of Apple Inc.’s shares, up from 7% at the end of 2009. Of the four largest U.S. banks, the fund companies together own 20% of Citigroup, 18% of Bank of America, 19% of JPMorgan Chase, and 19% of Wells Fargo. The phenomenon can be even more pronounced for smaller companies. The Big Three own 28% of Cabot Microelectronics Corp., an Aurora, Ill., seller of materials to semiconductor manufacturers that has a market value of $4 billion.

“The fund companies say there’s nothing to worry about because they don’t vote as a bloc. And index funds don’t buy shares to pursue any special agenda—they just buy whatever’s in the index, usually in proportion to its market value. If passive managers weren’t grabbing up all these shares, similar power would likely be in the hands of active funds, which haven’t served investors nearly as well. Index fund managers are more technocrat than robber baron.

“And yet voting power is voting power. The fund companies’ combined votes and back-channel jawboning, in which they make their views known to directors and chief executive officers, could swing the outcome of important matters such as mergers, major investment decisions, CEO succession, and director elections—even if no fund house has the ability to decide the outcome of such matters alone. They’re potentially the most powerful force over a huge swath of America Inc. Alarm bells have begun to go off with some regulators, as well as with an ideologically diverse array of academics and activists.” With outstanding performance records and fees often just 0.04% of assets (they really do make it up in volume!), they are becoming irresistible to all but the most sophisticated traders.

Headquartered in the little town of Malvern, Pennsylvania, Vanguard Group is one of the most powerful financial institutions on earth, yet smaller than Black Rock or State Street. By itself, it attracts $10 trillion of assets, and some academics, competitors and government regulators are beginning to question such a massive concentration of power. Little old Vanguard: “Once an upstart investment company shunned — even mocked — by rivals, Vanguard has disrupted the investment management world. The cheap index-tracking funds championed by late founder John Bogle helped batter down fees across the industry and have attracted $10 trillion of assets. The company is now cautiously expanding in Europe, China and elsewhere, moving deeper into financial advice, and even exploring whether it could offer its customers private equity funds.

“‘The sheer size of Vanguard and the income that it generates allows us to invest more for our clients, roll out things like advice, enter new markets,’ Tim Buckley, Vanguard’s chief executive, said in an interview. ‘Our size gives us the ability to do it while still lowering your costs to improve your returns.’ Disruption, however, ruffles feathers. Moving further into offering financial advice, it competes with wealth managers and financial advisors who offer Vanguard products.

“International expansion also takes it into less hospitable terrain. There are concerns that the inexorable tide of ‘passive’ funds — which track a stock or bond index, as opposed to ‘active’ investment picks designed to beat the market — are distorting markets and weakening corporate governance.” Los Angeles Times, January 20^th.

These funds wield the equivalent power of governments in nations with small or even mid-size national wealth. A big mistake, a big fall, in a small company may not mean that much to our entire economy. But when three financial structures control this much…. what could possibly go wrong, go wrong, go wrong? Boom!

            I’m Peter Dekom, and one might hope that each of these funds is run by a genuine “stable genius” with a whole lot of ethical boundaries…