The Effects of Auto-Pilot

Let’s face it.  It’s hard to beat the market.  Those who can do so consistently are few and far between and get paid serious money.  Whereas investing in a fund that tracks the market– a so-called “passive” fund because there’s no active choosing of individual investments – is like being on auto-pilot; it’s easy and low cost.

So, it’s no surprise investors big and small often put a portion of their money in passive funds like indexed mutual funds and exchange traded funds (ETFs).  A large chunk of these funds track the S&P 500 or Russell 3000, but passive funds can follow a myriad of other indices.

Over the last decade, passive investing has grown prolifically, from approximately $2 trillion to $10 trillion today, representing nearly 40% of assets under management.  Rapid change can make people uncomfortable.  As a result, some are raising questions about the broader effects of auto-pilot investment funds.  For example:

  • Can passive investing fuel a bubble or increase financial instability?
  • Does it crowd-out small, high-growth companies from the public markets?
  • Does it, or can it, distort the capital allocation process?
  • Does it stifle competition? Or create an anti-competitive environment?
  • What is, or should be, the role of these passive institutions in exercising oversight over their investments?

Serious questions, but can we really pin all this on passive funds?  Let’s take a closer look.

By definition, passive funds are designed to follow an index (however defined). Accordingly, they own a market-capitalization weighted interest in the companies comprising that index and rebalance their portfolio on auto-pilot.  Consequently, passive funds are followers, not leaders, of market trends, so it’s hard to imagine them causing a speculative bubble or bust.  Yet, some research indicates that the increased size of passive funds, their use of leverage and derivatives to manage risk plus market correlations among and between stocks, may result in passive funds increasing market vulnerabilities to idiosyncratic events. For example, when multiple funds on auto-pilot simultaneously buy and/or sell the same stock or if they suffer a liquidity event in the face of a rash of fund redemptions.  The good news is research shows passive fund holders tend to be less reactive, so the latter is not too likely.

Next, it logically follows that as money flows into index funds and ETFs, there is a proportionate increased investment in the companies comprising the indices.  Since generally larger companies belong to an index (depending on the specific index), passive funds basically facilitate the big getting bigger. Indeed, since 1997, we’ve seen the average market capitalization of public companies increase, while the number of public small-cap companies has dropped dramatically.  However, other factors such as industry consolidation, M&A and robust venture capital and private equity markets are also drivers of this trend.

In a similar vein, passive funds are, in essence, allocating capital to the underlying components of an index without regard to a specific business’s opportunity or fundamentals.  Sanford Bernstein analysts argue this is sub-optimal with potential long-term economic consequences as compared with active management, or even Marxism.  This is because under active management and Marxism, investing agents seek to optimize capital flows in an economy based on desired objectives or principles.  This is an interesting concept and one that bears watching, but in my opinion not critical at this time since passive investing represents less than half of all assets under management and access to capital remains robust through the debt, private equity and venture capital markets.

While not unique to passive investing, it’s very common for indexed mutual funds and ETFs to hold competing companies in the same industry.  Some academics theorize this could lead to anticompetitive behavior.  The thinking goes that given these funds’ portfolio optimization goals, some fund managers may try to influence the competitive strategies of portfolio companies so as to limit the negative impact portfolio companies in the same industry have on each other.  Amplifying this concern is the high level of common ownership at institutions and the collective influence they can bring to bear on companies.  This theory is a stretch in my view given my understanding the nature and behavior of institutional investors; the fiduciary responsibilities boards have to all – not just some – investors; and the significant compensation incentives managements have to optimize business performance.  Nevertheless, this theory has enough traction that the Federal Trade Commission held an open hearing on the subject in December 2018.

Finally, the major passive institutions can have a powerful voice in the corporate world given their ownership stake and corresponding proxy voting power.  Largely they have used this voice to focus on governance and board accountability matters, such as board operating principles and composition – including diversity. They are also focused on how well boards exercise their oversight of executive leadership, compensation, company strategy, corporate culture and risk management.  This includes asking boards to ensure companies assess relevant social and environmental risks.  As part owners of a company, passive investors have every right to expect boards to execute such responsibilities effectively.  Still, there’s a delicate balance between asking thoughtful questions and offering perspectives and being accused of overreach.

Deep breath here. Passive funds are not the source of all the business world’s problems – or even half of them. While passive investing has grown to a significant level rapidly, passive fund managers act and work independently, compete against each other for client dollars and have differing priorities.  In the end, passive funds have been a boon to a broad swath of the investing public and if there are any unintended consequences of their growth or size, it should be handled with a scalpel, not an axe.

Lisa Ciota
Lead-IR Advisors, Inc.

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