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The Passive Investor Problem

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When John Bogle died in 2019, people around the world mourned. Bogle created the Vanguard Group and made the index fund mainstream. Index funds are investment vehicles that invest in a class of investments as a whole, rather than trying to predict what specific stocks or securities will do best. So an investor could invest in an index fund that represented American companies as a whole rather than trying to predict whether Disney, Apple, or Meta would have a better quarter.

The theoretical advantage of these index funds is that they can theoretically offer diversification across many investments, exposure to most types of assets, and crucially offer lower fees by eschewing active management. When he died, it was estimated that by popularizing index funds rather than higher-fee mutual or hedge funds he had saved investors a trillion dollars in reduced fees. The Vanguard Group has grown to be enormous with over $7 trillion in assets under management.

But as Vanguard and other similar groups have grown, a larger and larger share of most companies’ stock is held by funds that have little interest in the performance of any particular company. If an investor bets big on Apple, that investor will have a good reason to carefully monitor Apple’s performance, carefully consider how to vote in shareholder elections, and serve as a watchdog on management because of their investments. With index funds, every investor can end up so diversified the performance of each company matters little to investors. It also means that a few investment companies can end up controlling a large or sometimes majority share of every major company. In 2019, the Harvard Business Review pointed out that “either Blackrock, Vanguard, or State Street is the largest shareholder in 88% of S&P 500 companies.”

This common ownership discourages competition. In a world where every company has different owners, every company competes to maximize its profits, often taking market share away from its competitors. But what if every company is largely owned by the same few institutional investors? A company that tries to maximize its profit- perhaps by cutting prices and saving consumers money- will also hurt the other companies that its investors also own. Shareholders may come to care about the profits of an industry as a whole rather than the profits of a particular firm, tacitly encouraging anti-competitive behavior.

It also means that ideological crusades can be driven by a few investment companies. It’s hard to imagine small firms going all in on DEI or ESG investments. What small family company wants to abandon hiring the best job candidates in the name of diversity or adopt unproven “green” practices in the name of sustainability? But if a few investment managers become passionate about such trendy left-wing ideas they can rapidly disseminate through the market. 

You might think that competition might winnow out ESG, but if fund managers force such practices on every major firm that suddenly becomes much less of a concern. 

This problem is mainly, but not solely, an equities problem. Bondholders never had a vote in shareholder elections but even so, they might prefer more invested and active shareholders to preserve the company whose debt they own. Other popular types of investments such as gold and other precious metals and real estate are less affected by the rapid rise of passive investing.

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