Conclusion: index funds are (again) changing the world

By on October 15, 2021 0

NEW YORK, October 15 (Reuters Breakingviews) – For regular investors, the bad old days were really bad. Many people remember that buying mutual funds involved paying an 8% charge up front, a huge handicap for the bettors in question. These friction costs were one of the driving forces behind the idea of ​​following market indices at low prices rather than entrusting savings to expensive stock pickers.

The revolution was late. Academic research had shown that these particular masters of the universe underperformed larger markets at the start of the second half of the 20th century. Despite false starts, this idea eventually led to the creation of index mutual funds starting in the 1970s and, in the latest incarnation dating back to the 1990s, exchange traded funds or ETFs. Finance will never be the same again.

The story of how this happened provides the subject of “Trillions” by Financial Times reporter Robin Wigglesworth. It’s a detailed and engaging tale, featuring characters including the indomitable John “Jack” Bogle, founder of the Vanguard Fund powerhouse, Larry Fink, architect of the even taller BlackRock (BLK.N), and Louis Bachelier, a French mathematician whose 1900 doctoral thesis made an early contribution to the academic foundations of passive investing.

The remodeling came quickly. In U.S. financial markets, index funds accounted for 40% of the $ 25 trillion total invested in all funds at the end of 2020, up from less than 20% of a much lower total in 2010, according to the Investment. Company Institute. Among trackers, US ETFs have now overtaken mutual funds. The United States is at the forefront, but it is a global phenomenon.

Wigglesworth weaves the different stories with flair, depicting the people and the tensions and corporate reconfigurations involved, such as BlackRock’s $ 13.5 billion acquisition of Barclays Global Investors in the midst of the 2008-09 financial crisis. The takeover of the UK bank’s iShares unit proved to be a pivotal moment for Fink’s now all-powerful index tracking business. In its latest earnings report, the company, with a market capitalization of around $ 130 billion, reported $ 9.5 trillion in assets under management, including $ 6.3 trillion in mutual funds. indexes and ETFs. This brought in $ 5 billion in quarterly revenue and $ 1.7 billion in profits, two records.

The author intentionally avoids going into the technical details of index funds and ETFs. This leaves room for many anecdotes, but for a reader already familiar with the outlines, the gap leaves a thirst. Still, the stories of who followed the indexes, who failed, and how different people got along or clashed, make it an enjoyable read.

Wigglesworth concludes that funds that track benchmarks like the S&P 500 Index of Large US Equities have been a clear boon to investors. It is a fair assessment. There is no doubt that the products made investing more accessible while removing much of the expense that went out of the pockets of fund managers and salespeople.

Yet he does not shy away from the questions raised by the upheavals in the industry. For example, passive funds cannot choose which stocks to invest in. If they can’t vote with their feet by selling a position, and if they’re performing so poorly that they can’t afford to employ dedicated analysts, can they really hold a company’s management accountable? ? Stewardship initiatives, including for example BlackRock’s vocal positions on issues such as climate-related disclosures, are helping to address this to some extent, but it’s just the start.

There also remain questions about the stability of ETFs in a crisis, perhaps especially when a fund tracks less liquid instruments such as corporate bonds rather than stocks. Industry cheerleaders point to a tightening bond market in February and March 2020 as evidence of product strength, while skeptics say the U.S. Federal Reserve came to the rescue too soon to justify this claim.

Other concerns include the emergence of a new set of players with growing influence that has gone beyond the regulations adopted for an earlier market structure. Among them are proxy advisors, an area dominated by two companies, Glass Lewis and Institutional Shareholder Services. Essentially, they tell fund managers who outsource this work how to vote on issues put to shareholder votes.

Perhaps even more important are the now innumerable index providers, some of the biggest being the MSCI, FTSE Russell and S&P Dow Jones indices. As Wigglesworth puts it, index funds “in effect delegate their investment decisions to the companies that create the benchmarks”. In short, index providers are the new active managers.

Even when the parameters for inclusion in the index are objective, companies can change their behavior to enter, because being part of a benchmark requires all investment vehicles that follow it to buy the shares. But the criteria are not always black and white. Even the selection of components of the S&P 500 involves subjective decisions on the part of the index supervisors.

The huge increase in value of electric car maker Tesla (TSLA.O) as it waited and then joined the benchmark is one example of the difference the inclusion of the index can sometimes make. A discussion paper released this month by the National Bureau of Economic Research suggests that companies that pay for credit ratings from S&P Global, which also owns the indexing business, “appear to be improving their chances of entering the index “.

Causation is difficult to demonstrate conclusively. But where humans participate in decisions that can involve billions of dollars, other humans will try to influence them, and again, others will become suspicious of their motives and incentives. When the sums at stake reach billions of dollars, the integrity of the industry is at stake.

There are still few clear answers. When index funds, and ETFs in particular, exist for another decade or two, researchers and watchdogs will have gathered more data to work with. That’s when “Trillions” will need a sequel.

To follow @ richardbeales1 on Twitter

NEWS CONTEXT

– “Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever” by Robin Wigglesworth was published by Portfolio on October 12th.

Editing by Peter Thal Larsen and Amanda Gomez

Reuters Breakingviews is the world’s leading source for financial calendar information. As the Reuters brand for financial commentary, we dissect big business and economic stories from around the world every day. A global team of around 30 correspondents in New York, London, Hong Kong and other major cities provide real-time expert analysis.

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