Home
 Portfolio Manager
 Fund
 ETF
 Fund Tools
 Fund Selector
 Funds to Explore
 Category Quickrank
 Guaranteed Funds
 

What Happens If Everyone Indexes? (Part 2)

Alex Bryan discusses some possible consequences.

Alex Bryan, CFA 26/09/19

We continue the conversation between Christine Benz, Morningstar’s director of personal finance, and Alex Bryan, Morningstar’s director of passive strategies research for North America, on the topic of the popularity of indexing.

Christine Benz: So, what's the solution [for index front running]? Assume I want to track, say, a small-cap stock index, or I want that type of exposure in my portfolio, how should I address it to not be disproportionately burned by this problem?

Alex Bryan: So, I think there's one or two solutions. Number one, you could just own a total market index, where you're kind of on both sides of these trades, and it's a wash. So, if I own something like the Vanguard Total Stock Market Index, yes, there might be some stocks that go into and out of the S&P 500 that are negatively impacted by that, but I already own them if I own the Total Market Index. So, I think that's one solution.

Now, if you want specific exposure to an area like small-cap stocks or high-yield bonds, I think it's a good idea to look for funds that are a bit less popular that have fewer assets tied to them, because that means that when there's changes to those  indexes, there's less market pressure on the prices of those stocks, because there's less dollars going into or out of them. So, I think that's one thing to look for.

The second thing you want to look for is indexes that are taking steps to mitigate unnecessary turnover, because a lot of times, well, turnover is costly and a lot of times it doesn't add a lot of value. So, if you, let's say, you're a small-cap stock, and you migrate slightly into mid-cap space, well, that stock is probably going to have very similar performance to other small-cap stocks. So, it may not be worthwhile selling that. It may be OK to hold on to that. So, I think a fund like, let's say, Schwab U.S. Small Cap ETF. That's a less popular fund, and it's one that tracks an index that applies wide buffer zones to try to mitigate these types of unnecessary turnover trades.

Benz: So, the buffer zone is there to keep things from slipping back and forth out of the small-cap space?

Bryan: That's right.

Benz: Let's talk about the last potential concern related to the growth of indexing. And that is that it could cause businesses to be less competitive, or it could cause the complexion of industry to be less competitive. Let's talk about how that would happen, why that would happen as a result of the growth of indexing.

Bryan: So, the concern is that index investors, asset managers who manage these, they own all the companies in the market. So, they don't necessarily have the same incentive to pressure managers to maximize the value of any single company. They may not be as concerned about one firm winning at the expense of another because they want to see all the firms in industry win. So, that's the concern is that this could potentially harm consumers, because it might create some anti-competitive behavior in the same way that if you see consolidation in a given industry, there might be less competition. The concern is that that same effect would happen if you have a couple of big institutional investors like BlackRock and Vanguard own all the airlines, for example.

Benz: Right. Right. So, there's been some academic work on this topic, looking at a couple of different industries. You have written about this topic before as have some of our other colleagues. Do you think this holds water? Should people be concerned about this?

Bryan: I think it's a weak argument for a number of reasons. Number one, I think managers of most companies are heavily incentivized to maximize their own shareholder--the value of their own company.

Benz: So regardless of external pressures?

Bryan: Regardless of external pressures, regardless of who owns the firm. I think managers in most companies, because they're paid very heavily in stock of their own companies and their bonuses are tied to their earnings and to their revenue, they're not really concerned about maximizing the industry's profitability, they're concerned about maximizing the results for their own firm. So, I think that's the first thing.

The second thing is that this argument makes this assumption that it's always in the firm's best interest or almost always in the firm's best interest to compete more aggressively. And I think oftentimes, it's just not the case. If GM, for example, were to cut prices on its automobiles, it knows that Ford is likely going to react and both companies will be worse off. So, I think the ownership of a company doesn't affect the optimal competitive strategy.

The other thing to note is that most index managers aren't really talking competitive strategy or pricing when they do engagements with their portfolio companies. They're more concerned about corporate governance, things like making sure that the board has proper experience, that the company is taking adequate steps to manage risk. They're not really talking about what business strategy the firm should pursue.

The other point I would note is that even if asset managers did want to influence corporate strategy, it's not obvious that they would want to maximize profits at the industry level, because they own all companies across all industries. So, higher ticket prices in the airline industry could actually hurt their holdings in the hotel industry. So, they may not necessarily want that. So, it's not obvious that index ownership is going to lead to less competitive behavior. I think at this stage, the argument is interesting, but I think it's a more academic argument and the empirical evidence really isn't persuasive as of yet. So, I think there's more work to be done in this area.

Benz: Put that one on the backburner for now. Alex, it's always great to get your insights. Thank you so much for being here.

Bryan: Thank you for having me.

About Author Alex Bryan, CFA

Alex Bryan, CFA  

Alex Bryan, CFA is the Director of Passive Fund Research with Morningstar.