The so-called big three indexed fund providers — Vanguard, State Street and BlackRock — are estimated to have controlled about 15 per cent of the S&P 500 in 2017. More broadly, more than 44 per cent of assets in US-domiciled equity funds are now managed passively, up from 19 per cent in 2009.
If anything, these figures underestimate the power of passive fund managers because large numbers of shareholders do not vote, even in contested battles, so the voting power of those who do vote is leveraged.
At first blush, passive fund managers scarcely look cut out for engagement with management. Because their portfolios are far larger than those of active managers, the cost of monitoring and conducting a dialogue is high, especially given that they operate a very low-cost business model. Yet even with small governance teams, they can exert considerable power vis-à-vis corporate management because they tend to have similar attitudes and voting policies and are pivotal when it comes to control contests, activist campaigns and mergers.
Hence the increased correlation in shareholder votes, particularly among the big three. Chief executives are acutely aware of all this. Mr Coates also points out that for a given portfolio company, growth in the size of an index fund will result in more shares being held, which is why concentration resulting from indexing is growing so fast. For each additional share and each additional dollar of assets under management, there is no additional cost to forming a view on a policy issue and applying it to the same company.
He also argues that the conflict of interest in the fund manager’s position evaporates because voting power means a chief executive is more likely to want to offer business to an indexed fund manager than take it away. The difficulties inherent in this concentration of power are the same as those that apply to the stewardship approach to investing more generally. Do these indexed fund managers have the competence to make important judgments about the strategy and management of individual companies?
There are questions, too, about legitimacy and accountability in relation to these unelected individuals who exercise power behind closed doors over the shape of the corporate landscape and the job prospects of millions of employees.
And then there are antitrust issues. In a business with big economies of scale, incomers confront huge barriers. There will thus be, at the very least, calls for greater transparency, though surely not for drastic breaking up of indexed funds. They have given investors too good a deal for that to make sense.
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