Tracking the Market

At the time of the 2008 financial crisis, the asset management industry was both smaller and much less concentrated. In the nearly fifteen years since, a handful of firms have skyrocketed to their current positions of dominance, in large part through their cornering of the market in “index-tracking” or “passive” funds.

Like any investment fund, passive funds pool together the resources of individuals or organizations and use those resources to invest in a range of securities, primarily the stocks and bonds of public corporations. For much of the industry’s history, the decisions as to how to invest — how much of which stocks — were made by a team of managers and their analyst underlings who researched companies and macro trends in an effort to beat the market. The advent of the index-tracking fund, as Financial Times journalist Robin Wigglesworth documents in his book Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever, turned this model on its head.

Originally dreamed up by Vanguard founder Jack Bogle in the late 1970s, the index-tracking fund, as the name suggests, tracks a predetermined index of securities. The S&P500 is a good example: any fund tracking this index will buy up shares in these companies in proportion to their weighting in the index, which is typically “capitalization” based, meaning it is related to the company’s total value.

In contrast to the wolfish machismo of the alpha-seeking Wall Street imaginary, index funds don’t try to stock pick in an effort to beat the market. Instead, their only job is to replicate the returns of a given index. So, if the S&P500 is up 7 percent, so is your fund.

Buffett’s Bet

The idea was slow to take off. At the time, a rival investment firm even distributed a flyer with the slogan “INDEX FUNDS ARE UNAMERICAN!” emblazoned over a portrait of Uncle Sam. But eventually, the index fund’s luck began to change.

Wigglesworth recounts the story of a 2007 bet between Warren Buffett and a hedge fund manager named Ted Seides: Over ten years, Buffett wagered, an index fund tracking the US stock market would outperform a pooled selection of hedge funds. He placed a cool $320,000 on it; in fact, in true investment magnate form, both parties did, putting the money into a Treasury bond that would be worth $1 million at the bet’s conclusion in 2018. For Buffett, the bet paid off.

The evidence in favor of the outperformance of index funds has mounted over the years. As Wigglesworth writes: “Data is a hard taskmaster, but has consistently shown that while someone might get lucky for a few years, very few do so in the long run.” In short, across the board, active funds have broadly been unable to beat their passive counterparts.

Since 2008, the index fund has taken off, in part due to the gaping hole the financial crisis opened in the justification for the often-exorbitant fees of traditional managers and to the comparative stability these funds are perceived to offer. In the years since, passive fund assets have ballooned worldwide. In the United States, there are now more assets in passive than in actively managed funds — a monumental shift in the nature of investing and capital allocation. The UK is not far behind, although the gap is closing more slowly.

Cutting Out the Middlemen

The index fund is a controversial animal. It tends to carry the specter of automation that haunts the discourse around work, as though we are yielding our autonomy to the automatons. Climate campaigners have raised concerns about the ways in which passive investing undermines divestment, which is also the only real threat that asset managers hold in trying to discipline companies into decarbonizing.

The rise of the index fund has also radically changed the distribution of ownership in the corporate economy, driving the relentless rise of titans like BlackRock (which offers primarily passive funds) and Vanguard (an almost exclusively passive provider). But others, including Wigglesworth, point out that these funds have a democratizing and inequality-combating function: by drastically lowering the fees associated with investment management, index-tracking or “passive” funds have opened up the world of investing to a whole new suite of people who previously couldn’t afford to access it.

The average hedge fund might charge 2 percent on the assets it manages, plus a 20 percent cut on any profits they make; the average index fund, by contrast, charges just a fraction of a percent on the assets it manages and is more likely than not to produce better returns. Recently, fund providers have started offering index-tracking funds with no fees — a reflection of the steep competition in the industry. As Wigglesworth notes, the savings in fees from the shift to index investment “amount to trillions of dollars, money that goes straight into the pockets of savers, rather than highly paid finance industry professionals.”

There’s definitely something to this. One of the most significant injustices stemming from the existing investment system is that it provides preferential access to an essential tool for growing one’s wealth, generating huge economic inequalities that cut harshly along racial lines. Moreover, as Buffett himself argues, their questionable value creation makes the outrageous fees accrued by freewheeling and routinely underperforming managers difficult to justify.

The Big Three

I’m not sure, however, that my assessment is quite as glowing as Wigglesworth’s when he argues that, in the face of widening economic inequalities, “the positive impact that an initially much-maligned invention by a motley group of self-described finance industry renegades and heretics can have in the space of a few decades is inspirational.” While data is indeed “a hard taskmaster,” or in some cases not readily available, it would be difficult to argue that index funds have had a big impact in closing the gap between the “haves and have nots,” as Wigglesworth suggests.

In both the United States and the UK, where index funds have had the greatest traction, inequality — particularly in financial assets — remains profound. As of 2020, the top 10 percent of the US population held 88 percent of corporate equity, either through direct shareholdings or funds. The bottom 50 percent held just 0.8 percent. The picture in the UK is not far off this pattern.

There is no denying Wigglesworth’s argument that the boom in index funds has kept money out of the pockets of bullish fund managers, and we’re in agreement that this is, on its own, a positive turn of events. Whether this represents a widespread victory for the common man, however, is much less clear.

While it may have reduced fees across the investment industry, the boom in index funds has also contributed to the relentless concentration of assets and power within the behemoth asset management firms that I named at the start of this review. BlackRock, Vanguard, and State Street have cornered the market on passive investing. In the process, they’ve also managed to corner ownership of the global economy.

Together, these so-called “Big Three” asset managers, all of which are US-based, own an average of over 20 percent in any given S&P500 company from the index of the 500 largest US corporations — everything from Amazon, Facebook, and Tesla to Pfizer, Exxon, and American Express. In the FTSE350, which aggregates the 350 largest corporations on the London Stock Exchange, they control an average of 10 percent.

Universal Owners

Today, a historically novel set of traits defines the relatively small cohort of titanic firms at the top of the asset-management food chain. First, they are “universal” owners, insofar as they have holdings distributed across the entire economy — every industry, geographical region, and asset class. Second, their positions in these holdings are broadly speaking relatively “strong,” which means they have relatively significant stakes across the board.

Third, they operate on a fee-based model, whereby they earn a percentage based on the size of the pool of assets they’re managing. These features, combined with the industry’s extreme concentration, together constitute a new regime of ownership and logic of corporate governance that academic Benjamin Braun calls “asset manager capitalism.”

The shareholder of the Thatcherite “shareholding democracy” imaginary was a different beast altogether. As an individual, you might be able to hold a few shares in a handful of companies, meaning you had an acute interest in how those companies behaved — what they paid out in dividends, whether they behaved responsibly or criminally, and so forth. Moreover, the average holding would be small and shareholders diffuse.

Conditions today are radically different. The combined stake of circa 20 percent held by the top passive managers often constitutes a decisive voting bloc at corporate annual general meetings. Their outsize stakes also give managers privileged access in behind-closed-doors engagement with corporate management, which is where the real action often happens. Overall, this represents a profound shift in the arrangement of ownership and control in the global economy away from the idealized “shareholder democracy.”

The Tracking-Error Taboo

How are our new “corporate overlords” (as one Trillions chapter title labels them) using this immense power? In short, it’s complicated. As Wigglesworth documents, the ethical and moral dilemmas raised by the preeminence of index investing in their business models first came to a head for the passive giants in the wake of the 2018 Marjory Stoneman Douglas High School shooting in Parkland, Florida.

At the time, activists pointed out they were among the largest investors in the major gun manufacturers and demanded that they take a stand. As a former senior executive told Wigglesworth, “Parkland was interesting. It was such a tough question for an organization like BlackRock. Are you going to make a moral statement and sell those gunmakers, but introduce tracking error?” (A tracking error is a discrepancy between the returns posted by the index and the returns of your fund.)

Arguably, the major index providers have been facing this criticism since before the Parkland tragedy, particularly from the divestment movement. But Parkland was perhaps the first time they listened.

In the end, they held their positions in the funds but “vowed to meet with the gunmakers and ask for plans on how to mitigate the risks” of their business. Short of shutting down production, it’s hard to gauge what they might have asked for. The whole series of events pointed to a fundamental question the climate movement has been consistently prosecuting with respect to the proliferation of index investments: the idea that there is “no exit.” In other words, as Wigglesworth argues, “The reality is that index funds cannot sell their shares.”

Whether the companies in question are arms manufacturers or fossil fuel giants like ExxonMobil, time and again, the asset management industry has pointed to the mechanics of index investing and simply shrugged. They argue they are obligated to minimize tracking error and pass the buck of portfolio allocation over to the index providers. Forthcoming research at Common Wealth underscores this point, finding that passive funds are becoming “holders of last resort” in the fossil fuel industry, even as active management moves out of the sector.

Campaigners have long pointed out the obligation to avoid tracking error is not, strictly speaking, a legally binding requirement. BlackRock’s recent announcement that it is no longer buying Russian securities across both its active and passive lines certainly calls this convenient excuse into question. But the industry norm, practice, and received common sense is, overwhelmingly, that an index fund cannot divest at will. This means there are serious questions to be asked about who ultimately is calling the shots in today’s investment industry.

Indices of Power

Without question, the seemingly inexorable growth of and concentration within BlackRock, Vanguard, and a small cohort of other giants represents a tectonic shift in the nature of ownership, control, and corporate governance. Their power — particularly that of BlackRock — today extends far beyond financial markets and directly into the most hallowed halls of politics.

Several BlackRock alumni occupy spots in the Joe Biden administration. BlackRock received authority to allocate the Federal Reserve’s corporate bond purchase program in response to COVID-19 — buying up several of their own ETFs in the process. Yet this ascent to power has been closely if much more quietly mirrored in the slowly accumulating power of the index providers themselves.

The indices that funds track can come from a range of sources; often, big firms like BlackRock might construct their own in house. Generally, however, in part because of the resources required to construct and maintain them, a passive fund will be tracking an index from one of three external providers: MSCI, S&P Dow Jones, or FTSE Russell.

If concentration within the asset management industry itself is substantial, the index providers set an even higher bar. As academics Eelke Heemskerk, Jan Fichtner, and Johannes Petry have documented, these three firms control more than 75 percent of the market in indices. As the passive industry grows, this gives these providers a profound degree of influence over capital allocation in the global economy. Heemskerk, Fichtner, and Petry describe their influence as representing a new “private authority” over access to capital that increasingly rivals the World Bank and the International Monetary Fund.

This is not purely speculative. Journalists, academics, and asset managers have begun to play close attention to the extent to which indices no longer just reflect markets but actually move them. In other words, instead of simply reflecting existing market conditions, the index industry is now so influential that its decisions can trigger significant changes in global capital allocation. Even the prospect of a company’s being added to a major index can materially inflate its share price before that status has been officially confirmed.

Corporations are also beginning to change their behavior to meet the incentive of index inclusion. For instance, one study found a relationship between the scale and duration of corporate bond issuances and the drive for index inclusion, as only bonds meeting certain thresholds would merit widespread inclusion. One Canadian oil firm even moved its headquarters to Colorado so that it would be featured in key indices.

It’s not only the private sector that is affected by this “market moving” capacity. Each year, MSCI, one of the world’s largest index-providers and ESG (environmental, social, and governance) ratings agencies, determines which countries are considered “emerging markets,” which means that the country’s sovereign debt will be included in countless financial products and investment strategies. In 2018, MSCI chose to restore Argentina — which had previously been relegated — as a member of their emerging markets index. Within a single day, the “Merval,” Argentina’s flagship stock market index of major corporations, spiked 6 percent.

It seems transparently and profoundly irrational for a team of analysts at a single US company to determine the often life-and-death constraints on access to capital for sovereign states and the price they have to pay for it. Yet few observers have raised the alarm about this state of affairs.

Ducking the Issue

Robin Wigglesworth does dedicate a section of Trillions to this question. He quietly acknowledges that, in spite of the perception that indices are somehow an objective reflection of market conditions, in reality, their construction often involves several subjective choices, which means that “an element of human discretion is inevitably and unavoidably part of the process.” He also acknowledges that the “indirect consequences” of these often-subjective decisions can be “huge.”

However, Wigglesworth stops short of fully questioning the injustice and irrationality of this setup. He simply concedes, when discussing a relatively niche decision made by S&P over share classes, that “one could argue that these are areas best left to lawmakers and regulators, not private companies.”

This unwillingness to name the injustices and concerns posed by the rise of the index fund is, in the end, both the strength and the shortcoming of Trillions. On the one hand, in true journalistic form, Wigglesworth has meticulously and compellingly documented the history of the index fund, with a cast of well-formed and interesting characters. He also offers the arguments of industry and academic critics in good faith, highlighting their concerns in detail.

On the other hand, Wigglesworth’s enthusiasm for the David-and-Goliath tale of the humble index fund prevailing against the unjustified bravado of active managers and hedge fund magnates ultimately limits the book’s reflections on the problems that the industry’s rise might be creating. When dealing with the concerns of industry insiders or academics, he maintains an underlying stance of cynicism toward their motivations. Unfortunately, the unerringly optimistic concluding lines about the implications of the index fund minimize or brush aside serious questions about where power is situated in the economy and the direct spillover effects of such concentration, as in the case of BlackRock, into the political domain.

In the book’s final paragraphs, Wigglesworth pays tribute to his subject:

In the annals of Wall Street, the index fund is one of the few truly, nearly unambiguously beneficial inventions, a disruptive technology that has already saved investors hundreds of billions of dollars, sums that will undoubtedly reach trillions in years to come. Just consider the implications for a moment. Pretty much everyone saving for their retirement, to send their kids to university, to buy a house, or just for a rainy day indirectly or directly reaps the benefits of the humble index fund.

This may well be true, but I would contend that as the index fund continues to grow, these benefits — overwhelmingly limited, it should be noted, to people living in the Global North — will be outweighed by the risk of handing the reins of capital allocation over to a handful of financial analysts.

In an economy increasingly defined by financialization, control over the flow of capital is a profound, world-making power. If existing trends continue, this is a power that will concentrate within the hands of a cohort of asset managers and index providers that is both shrinking in number and ballooning in influence.

For the countries of the Global South and “emerging markets,” whose sovereignty over their domestic affairs is ultimately held captive by global financial markets, this is a daunting future. Call me a “skeptic,” but I’m not convinced that lower fees for middle-class Americans saving for a rainy day mean that, on the whole, the benefits of the index fund are “real, and enormous.”