When MSCI and S&P Rule the World
Sometime in the next four to seven years, passive investment vehicles will come to constitute more than 50 percent of assets under management in the U.S., analysts at Moody's Investors Service predicted in February.
This incipient triumph of index mutual funds and exchange-traded funds is to a large extent a triumph of common sense. Decades of research has shown active money management to be, on balance, a really bad deal for customers. With their emphasis on low fees and low turnover, index funds are for the most part a much better deal.
Still, it's impossible not to wonder what strange consequences the dominance of passive investing will have on financial markets. A team of analysts at Sanford C. Bernstein & Co. LLC famously argued last year that it was pointing us toward a fate "worse than Marxism." 1 New York University finance professor Jeffrey Wurgler didn't take things quite that far in a 2011 essay, but he did warn that "the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits while at the same time increasing its broader economic costs." And just this month, California Institute of Technology financial economist Bradford Cornell proposed that since we'll no longer be able to count on active money managers to set market prices efficiently, the corporations that issue securities will have to do the job.
Let's leave all those big-picture economic issues aside, though, and consider another one: If index funds come to dominate financial markets, then the people who compile the most important market indexes will basically run the world, right?
The decision makers at S&P Dow Jones Indices LLC, MSCI Inc., FTSE Russell and the like surely don't see themselves as all-powerful. They're just trying to build accurate representations of the markets that investors can invest in. But their decisions increasingly shape those markets as well.
We've seen evidence of that this week from the attention paid to MSCI's decision to include Chinese domestic shares in its global emerging markets index for the first time, despite concerns about how hard it can sometimes be for investors to actually buy and sell them.
Next up is a decision from FTSE Russell on what to do about corporations -- Alphabet Inc., Facebook Inc. and Twenty-First Century Fox Inc. among them -- with dual-share voting structures that allow insiders to retain control even after they sell the majority of the company to outside investors. Writes Richard Teitelbaum in the Wall Street Journal:
The proposal calls for setting a minimum threshold for the percentage of voting control attached to company shares in an index. For example, a company whose Class A shares in an index control 40% of the total votes might be excluded from FTSE Russell’s main indexes, like the Russell 3000 or Russell 2000, if the threshold were higher than that.
FTSE Russell, which has been soliciting investor input via Survey Monkey, expects to make the call next month. MSCI and S&P Dow Jones are considering similar changes. This wave of reconsideration was set off by the March initial public offering of Snap Inc., which sold the public Class A shares with no voting rights at all.
At the time, I wrote a column defending Snap's right to behave so tyrannically. Legal scholar Bernard Sharfman of the R Street Institute, a conservative/libertarian think tank in Washington, mounted that defense with far more erudition last week, concluding that:
It is an overreach for academics and shareholder activists to dictate to sophisticated capital market participants, the ones who actually take the financial risk of investing in IPOs with dual class share structures, how to structure corporate governance arrangements.
Index funds, pretty much by definition, aren't "sophisticated market participants." They strive to be knowledge-free investors, simply owning the stocks in the market (or a reasonable facsimile thereof), weighted as the index providers dictate. Sure, active investors can choose to avoid Snap shares -- and many of them seem to have been doing so since the IPO. But for passive investors, once it's on the index (and Snap is not on FTSE Russell's indexes yet), they have to buy.
So I sympathize with the predicament of groups such as the Council of Institutional Investors, a leading critic of dual-share arrangements, even if I'm not all that impressed by their argument (from the CII's response to the FTSE Russell proposal) that "unequal voting rights diminish accountability and are detrimental to public markets over the long-term." Those who oversee passive funds are understandably uncomfortable with having to own shares that give them no real ability to express displeasure with management.
What happens if the index providers cave to this discomfort and start excluding not just the extreme case that is Snap but other dual-share companies? A bad result would be if all corporate share structures converge on a single model -- diversity and experimentation are good, and some companies with dual shares have performed spectacularly well. If enough dual-share corporations stick to their guns, though, we might get a situation where some of the most promising companies in the world aren't available to index investors. Who knows, active investing might make a comeback.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
In response to that claim, my Bloomberg View colleague Matt Levine wrote a wonderful column that after trying and failing several times to sum up in a sentence I have decided instead just to link to here.
To contact the editor responsible for this story:
Brooke Sample at firstname.lastname@example.org