More passive than active?

talexuser

A study by Moody's says that by 2021 the money invested in passive funds will overtake that in active funds. 2018 saw the biggest outflow yet from US active funds leading the pack.

Will this change the balance of market competition? Do passive funds hold managements to account? I thought Jack Bogle said in one of his videos that there were problems of corporate governance coming?

fun4everyone

Passive funds are of great benefit to the retail investor. It's wrong to dismiss active funds, especially in the UK where the tax treatment of them is more generous than the USA but passive funds should always be the reference point. They are almost always the best choice for non experienced DIYers. I believe Bogle would have been talking about the USA with regards "corporate governance" but I am guessing as I did not watch the video you mention. The couple of things I believe most people misunderstand about passive funds are that Vanguards research is just as biased as active funds research. Also passive fund devotees accuse active funds of on average delivering below market returns. That's true, but passive funds also deliver below market returns on average and so would go into the "fail" category on their own research. I also believe a lot of UK investors read the USA research which is unfair due to the different tax treatment of active funds in the USA.

Personally I mix and match my portfolio and use both active and passive.

short_butt_sweet

fun4everyone wrote: »

Vanguards research is just as biased as active funds research

i see what you mean ... Vanguard believes in active management

Malthusian

The idea that passive investing is a bad thing because passive investors won't vote against the management and hold them to account ignores the fact that active investors don't hold management to account either, with very rare exceptions (who almost never have enough votes to do anything except get good publicity for their principled and consequence-free stand).

It is a hoary old cliche which makes no more sense than "if everyone tracks the index there won't be any index to track".

In reality corporate governance is like kickboxing in that voting with your feet is much more powerful than voting with your hands. If you hold a 10% share in a company and you think it's being badly run, you don't paint a few bedsheets and march down to an EGM, you sell your 10% shares before they tank and invest in something better. The Carl Icahns of this world are a very rare exception, and for their approach to work you have to be very confident that you can make the mountain come to Muhammed, and put a lot of work into persuading other shareholders to vote with you.

Passive funds of course do not vote with either hands or feet, and this is the deal you sign up to when you hold passive funds. The idea is that a few badly-run stinkers going south won't matter too much as they will only represent a <1% share of the index (for most mainstream index funds), and the fact that the majority of companies are averagely-run will ensure you participate in the overall growth of the market.

If it wasn't a made-up problem, the problem could be easily solved by putting in place a system where prior to a vote, active shareholders would signal how they intended to vote, and passive funds would then vote with the majority of active shareholders.

dunstonh

In reality, there is a lot of dross managed funds out there but some good ones. The majority of managed funds are dross. Many of which are computer controlled or even closet trackers at a higher cost. It is very easy to filter those ones out and leave you with a much much smaller pool of funds to select from.

The other thing to remember is that many active funds take on a different strategy to the index. Sometimes going lower risk, other times going higher risk or looking at areas that are just not covered by a tracker.

In some countries, like the US, passive investing makes sense due to internal taxation. In the UK, we do not have internal taxation. Some countries run in the 90%+ range of failing to beat passives. The UK does better than that. This is why hybrid portfolio methods are increasingly common nowadays. A mixture of passive and managed. Passive where passive is best and active where active is best. Those biased towards passive only or managed only are failing to take account of the advantages and disadvantages of both.

talexuser

I think Jack's point was that there a 2 very big passive holders, Blackrock and Vanguard, and eventually they would hold voting control of virtually every large US company. The corporate chiefs would be effectively unaccountable since passive funds rarely get involved with remuneration or investment policies. I find it hard to believe that once a CEO has 100 million dollars he is incredibly incentivised to perform better for more, surely hubris is the probable next step? Voting with your feet is the very good argument, but if passive is the majority, a minority voting with their feet might not be the most efficient market mechanism? But maybe at the end of the day it is the only one?

The Dunstonh one speaks wisely For 20 years I was active only researching the winners, which were few and far between. Now I have a substantial passive since not wanting too many eggs in one active, and not having enough worthwhile actives to go round.

short_butt_sweet

passive funds do vote on corporate resolutions. e.g. see https://www.institutional.vanguard.co.uk/portal/site/institutional/uk/en/about-vanguard/how-funds-voted for reports on how Vanguard (UK)'s funds voted. (you can also find their policies about how they use their votes.)

Bogle was probably making a point about concentration of shareholdings among a small number of managers, not about active vs passive as such. greater concentration may have some effects; i'm not sure.

however, it's a bit implausible to claim that its effects will include letting top executive pay get out of hand, when this has been happening for decades already, despite more dispersed share ownership. (it would need government action to get it back under control.)

talexuser

I don't think his point was passives alone have caused pay getting out of hand already, just the trend will just get exponentially worse the more passives dominate the market. You are right the only remedy is government reform action on reward for failure, since individual shareholders en masse have not had a great deal of success in changing the more egregious examples.

Alexland

If anything a passive manager might vote better as they are invested in the company for the long term.

bowlhead99

Alexland wrote: »

If anything a passive manager might vote better as they are invested in the company for the long term.

Nice thought, but they are only investing in it because it exists and because the theory says that the market will have valued it at fair price given its prospects.

The investors are not paying for the passive manager to employ smart people to consider a company's prospects or exercise judgement on what would be a good or bad course of action for the company given those prospects. The passive manager is not really incentivised to try to help its owned businesses do better at their respective businesses.

If their top holdings become better businesses and increase in value, the passive fund might make an extra fraction of a percent for the investors, and with a little more under management they can get more management fee income next year. However, if they improve those businesses through smart decision making and voting on corporate matters, the result of expending that effort is that the other rival funds tracking the same index will see the exact same gross gains, without the associated expense because they are not expending effort on things like 'making decisions, judgements and voting'.

So even though you might think it is a good thing for an index fund to make money for its investors to increase AUM and thereby its management fee income; it is perhaps better for it to cut its costs and get a reputation of being the most cost effective way to hold the index.

Example: if you grow your market share of index funds by 25% through cutting out non-essential personnel and building a reputation as the lowest cost tracker of a particular index per pound or dollar invested... that could increase your management fee income by 25%.

Whereas if you make awesome decisions at AGMs and EGMs by spending money on smart staff, skillfully evaluating businesses, voting in a good board and using your voting power to veto high boardroom pay and silly M&A activity, and literally double the value of the top twenty companies in your worldwide index... you grew the investors' money by less than 25% so your management fee income won't rise by as much as 25%.

Giving an impression of instilling good corporate governance in investee boards is nice for marketing. But when the prospective investors judge whether they should put money with Vanguard or BlackRock, a 0.01% cost saving on the OCF can swing the market share in a way that saying you have a great nose for business and high levels of corporate social responsibility, will not. Index investors are cost focused ; minimum tracking error and cost drag is key, rather than wanting to hold the best companies, because the index chooses the companies and the companies will be what they will be.

Alexland

bowlhead99 wrote: »

The investors are not paying for the passive manager to employ smart people to consider a company's prospects or exercise judgement on what would be a good or bad course of action for the company given those prospects. The passive manager is not really incentivised to try to help its owned businesses do better at their respective businesses.

Sure in a perfect world that matches your theory the passive asset manager would have elimited so much cost that a computer algortithm could do all the work. However as we know companies like Vanguard and Blackrock do have expensive offices, loads of expensive people and are excercising their votes as described above.

Alex