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Indexing: Every big trend has unintended consequences

August 13, 2017

Every big trend creates unintended side effects. Here are few examples from just the past few days:

  • A new $15 an hour minimum wage may actually be causing workers to lose their jobs.  (Washington Post)
  • Smartphones seem to be the cause in a rise of teenage depression and suicide.  (The Atlantic)
  • Donald Trump, who is no fan of the environment, is the best salesman for ESG strategies.  (The Reformed Broker)

In physics for every action there is an equal and opposite reaction. However in the messy world of human beings an action creates a reaction, but we just don’t know when, how or the size of the reaction. A great example of this is the trend towards passive or index-based investments. Assets have been shifting from active to passive since the end of the financial crisis. It is expected that more than half of equity AUM will be soon be indexed.

An obvious side effect of this trend may be that the price discovery process that active managers undergird may be degraded as more money flows into passive investment vehicles. Forty years ago when the first retail index fund went live issues like this were likely not on the radar of Vanguard founder Jack Bogle.

Passive investment has been a boon to the affluent and the upper-middle class, at the expense of a relatively small number of much richer bankers. But only about half of Americans own any stocks at all—the rest are consumers but not investors. And so they bear the weight of any damage caused by higher prices, not just for air travel but potentially for every product and service…Ultimately, the new theory of common ownership is a theory about inequality: To the extent that passive investing shifts costs to consumers, it makes the rich richer, and the poor poorer.

The push into passive is so large that it may be having effects that reach beyond the stock market into the real economy. Frank Portnoy in The Atlantic in an article with the catchy title “Are Index Funds Evil” writes about a thread of research that posits that common ownership, like that seen with the major index fund providers, in addition to market concentration can lead to price gouging. The economic issue raised is that the burdens of price discrimination don’t fall solely on equity owners they fall on consumers, many of which don’t own any common stock. Portnoy writes:

This theory, which had its origins some 30 plus years ago is not intuitive. That does not mean that it is wrong in practice. Whether it is ultimately true or not is really the point. The point is that the asset management industry is fundamentally changing. With price, i.e. expense ratios, essentially off the table as a competitive advantage going forward, asset managers are going to have to look for other ways to differentiate their products. Firms could in the future emphasize their corporate governance monitoring and proxy voting process as a potential marketing strategy.

The index fund trend is a big one. It will inevitably generate even more side effects than the ones we have already discussed. Some will positive, others benign, others unexpectedly negative. Investors will have to be vigilant along the way, and look both ways before crossing the street.

http://bit.ly/2hWC6rr

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