Massive liabilities: 50 years of the index fund
Happy birthday to index fund, who turned 50 this month – fitter, more spirited and more controversial than ever.
Five decades ago, John “Mac” McQuown, a stubborn former farm worker from Illinois, led a team of brilliant iconoclasts at a Wells Fargo skunk factory who invented ways to use state-of-the-art computers in finance. Among the things that the Management Science Unit helped birth were the famous credit scores of Fico and Mastercard. But the biggest was the index fund.
At one point, McQuown had six future Nobel Laureates in economics on his payroll. “This tells you how focused we are on the problem,” he recalls. The first clumsy iteration came about in July 1971, with $ 6 million from Samsonite’s pension plan. Soon after, two other unorthodox financiers – Rex Sinquefield of the American National Bank of Chicago and Dean LeBaron of Batterymarch – launched the first S&P 500 index funds.
The success of passive investing has been mind-blowing. There are now over $ 16 billion in index funds of various stripes, almost twice the size of the combined private equity, venture capital and hedge fund sectors. Add in some non-public internal passive strategies, and we’re probably talking well north of $ 25 billion.
Yet this success naturally aroused fears in parts of the financial industry, which was rocked by such a tectonic trend. Some of the concerns are overblown and probably a little selfish, but others sound like the truth.
The argument that index funds somehow destroy financial markets is the oldest and most popular argument. Already in 1975, analysts at Chase Investors Management Corp had warned that if the nascent trend of index investing continued to grow, “the entire capital allocation function of the securities markets would be distorted and only the companies represented in the indices would be. able to raise equity capital. . “
An anonymous mutual fund manager inadvertently made a more honest complaint to the Wall Street Journal in 1973: “If people start believing this garbage and move on to index funds, many portfolio managers and analysts at $ 80,000 per year will be replaced by computer clerks at $ 16,000 per year. It just can’t happen.
More recently, more cerebral financiers have presented compelling and alarming arguments about how the growth of index investing has gone from a good idea to a potential disaster causing volatility. However, what many critics seem to ignore is the fact that the financial markets are always on the move.
Yes, passive investing undoubtedly affects the functioning of markets. How could it not, both in broad markets and in individual stocks, given its growing scale? What is doubtful is that they “distort” the markets in more pernicious ways than any other type of investor who has come (and sometimes disappeared) over the centuries, from investment trusts to hedge funds. McQuown is downright dismissive. “It’s just complaining,” he says.
In fact, the fears surrounding indexing have strange echoes with the rise of mutual funds a century ago. A 1949 Fortune article on Massachusetts pioneer Investors Trust marveled at how the mutual fund had grown to $ 110 million, making it the largest stock owner in the United States, but s ‘worried about what might happen if investors withdraw their money at the same time. time. Today, skeptics worry the same with index funds, undeterred by the encouraging evidence from the major bear markets.
However, concerns about some of the more abstract effects are more difficult to dismiss.
Economies of scale in indexing mean that the big ones invariably get bigger. The specter of the three giants, a 2019 article, estimated that BlackRock, Vanguard, and State Street account for a quarter of all S&P 500 shareholder votes, and within two decades, they will likely represent up to 40%.
Indeed, Harvard law professor John Coates argued in a founding article 2018 that eventually, only 12 people could have de facto power over most American companies. “The effect of indexation will be to reverse the concept of ‘passive’ investment and produce the greatest concentration of economic control in our lifetime,” he warned.
Oddly enough, Professor Coates is now acting director of the Corporate Finance Division of the United States Securities and Exchange Commission. It’s hard to see what he could do to solve this problem, but it is undoubtedly a conundrum that will climb the agenda for the next decade.
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