Does a public bus take you to your destination? Well, kind of. It gets you closer to where you want to go, but generally pretty vaguely and slowly. Still, it’s much cheaper than taking a taxi, and probably safer and more dependable.
Index funds are the buses of the investment world. As evidence of this, take the conclusions reached by Matthew Ringgenberg, Davidson Heath, Daniele Macciocchi and Roni Michaely in an academic paper recently accepted by The Review of Financial Studies entitled ‘Do Index Funds Monitor?’
We find that relative to active funds, index funds are significantly more likely to side with firm management on contentious corporate governance votes. Low-fee index funds are even more likely to vote with firm management, which indicates that the low-cost structure of index funds directly affects their capacity to monitor. We find no evidence that index funds effectively engage with firm management either publicly or privately. As a result, we find that corporate governance worsens following an increase in index fund holdings. In sum, our findings all point to the same conclusion: the rise of index investing shifts power from investors to corporate managers.
The specific numbers they come up with are interesting. For contentious votes, index funds are about 10% more likely than active funds to vote with firm management; on votes relating to executive compensation, index funds are 11.3% more likely to vote with management. Further, executive pay tends to become less sensitive to the company’s stock price after index funds’ share of stock ownership increase.
In explaining why this might be, the authors note that the average index fund tends to hold three times the number of stocks that the average active fund holds. Index funds also tend to receive much lower management fees, and as the authors point out: ‘Because index funds have less resources and less incentives to increase the share price of the companies they hold, they may exert less effort to ensure corporate managers have incentives to maximize stock price.’
But also, the expectations for an active manager and an index fund manager are just very different. I don’t think anything above will come as a shock to index fund holders; flying out to Moline, Illinois to make a stink about corporate compensation doesn’t sound particularly passive to me. Investors in a dirt-cheap, widely diversified fund probably don’t think that they’re paying for this level of service. The bus driver isn’t going to drop you off right in front of your building.
Actually the bus metaphor may be a good one, because we appear to be dealing with a free rider problem. It’s well known that index investors seem to benefit from the investment choices made by active investors, since it is those investors who take it upon themselves to keep prices close to their fair values through the market pricing mechanism. But the authors add that index investors are also benefiting from active investors’ monitoring decisions, since ‘improvements to firm value are shared with all funds that follow the same index, but the costs are borne only by the fund that exerts monitoring effort.’
The other way of putting this is that we have a tragedy of the commons on our hands. Index investing is cheap, but the costs of index investors’ subpar monitoring are being borne by everyone, including the active investors. This could be bad for all investors, since overruling greedy decisions by company management becomes even more difficult when some large group of investors is pretty happy to vote with management no matter what.
One final point on this. We can agree that the rise of index investing grants more power to company management, but do we agree that this is a problem?
Some would argue that investors have become too powerful in recent years, and that allowing company managers to make decisions that help employees and stakeholders at the expense of investors is a good thing for society. At least, this is the argument that corporate managers have made with increasing volume lately, with the 2019 Business Roundtable statement serving as a prime example. Marty Lipton, the famed corporate lawyer and activist investor foe, recently wrote that an increasing focus on ‘inequality and injustice’ has led to a ‘substantial, salutary reflection about the role that corporations play in creating and distributing economic prosperity and the nexus between value and values.’
So not only are corporate managers getting more powerful, but they and their advocates are boldly declaring that this coup is good for society.
Well, is it? That question, unfortunately, cannot be answered by research alone. But if the authors are right that index funds are playing a role shifting the balance, then it seems likely that the growth in executives’ power will only continue.
Question time
‘Would that your problems were my problems, and mine yours,’ runs an old Yiddish saying. It’s an elliptical criticism of advice; it mocks our tendency to rather flippantly produce ‘obvious’ answers to the complex problems that our friends are kvetching about.
Or as Dan Solin puts it in a recent post on Advisor Perspectives: ‘The temptation to offer solutions for those facing a problem is overwhelming. Therein lies the trap for unwary advisors… If the answer to my friend’s problem was obvious, he would have thought of it.’
Working through a case study of an aging executive who’s torn between continuing to run his company and tending to his own health, Solin shows the value of what might be called ‘Socratic advising.’ Like a teacher who asks questions to stimulate thought and conversation (this is the Socratic method), Solin shows how asking questions – some information-seeking, some investigated, and some pointed – can help the advice-getter to effectively give the advice to themselves.
As a consequence, the insight that solves the problem is ‘unlocked’ rather than handed over. Better, the process becomes a mutual journey of discovery, rather than the delivery of a decree followed by some rhetorical strongarming. Since the solution was articulated by the advice-receiver, it’s probably much more likely to be followed.
Should more advisors integrate the asking of questions into their interactions with clients? If done well, such a process could allow the advisor to maintain a position of superior knowledge without affecting an air of superiority. Instead of, ‘You need to wait two more years before taking Social Security,’ it’s: ‘How would you feel about waiting two more years in order to increase your monthly benefit by 16%?’ In one framing, the advisor is as dictator; in the other, she is a knowledgeable helper.
And people generally prefer working with knowledgeable helpers.
This article originally appeared on citywire.
