The extremely simple and correct solution here is to not let index funds themselves vote. Only allow the votes to be cast directly by the index share holders. Problem solved, I don't know why people keep hand wringing about this and not suggesting the supremely obvious solution here.
> The extremely simple and correct solution here is to not let index funds themselves vote. Only allow the votes to be cast directly by the index share holders. Problem solved, I don't know why people keep hand wringing about this and not suggesting the supremely obvious solution here.
This is somewhat addressed in the article. One of the criticisms is that index founds don't do enough, resulting in more power to the CEO and less oversight. Giving voting power to individual owners would reduce engagement even further, giving even more power to the CEO. There might be some ways to improve this (let investors transfer voting power to e.g. non-profit organisation who vote for them) it's unclear if this would not simply shift the problem
Sounds like a self correcting problem easily solved by a little profit motive. As index funds gain ownership, the cost for an active investor to buy enough stock to vote whoever they want into control of companies decreases as the number of active voters decreases. Once that gets low enough and the CEO is deemed running a company badly enough, some active investor will buy enough stock to vote in better management and if successful, will rake in a healthy profit for doing so as it'll result in excess returns.
This is de facto already somewhat the case - most index funds lend out their shares to earn some additional income, and so they can't vote those shares.
However, this becomes a bigger issue as index funds gain additional scale. As shares owned by index funds further surpasses the number of shares demanded for borrowing, index funds will be left with more shares to vote.
This will likely reduce shorting costs and increase total shares sold short somewhat, but likely not enough to compensate for the additional index fund ownership (i.e., index funds will net still have more shares for voting).
That doesn't solve the big part of the problem which is the co-ownership of competing companies. A blackrock manager voting for you or you voting doesn't change anything. Through the fund, you co-own multiple competing companies, therefore you won't vote for policies that would increase competition between those companies.
I would say this does solve the problem. If you have enough money for your vote to matter, then you can just own all the stocks in an index yourself and get to vote. This is now even more practical as trade costs have recently been cut to zero for all major brokerages.
The average index fund owner is also not likely be spending time looking over the voting possibilities of 500 companies and aligning votes to decrease competition between them, even if that was possible. They just wouldn't vote on issues. The problem is that three funds can decided to vote on policies that reduce competition between companies and that they are big enough for the votes to matter.
Transferring votes to the underlying owners of the fund would in reality likely just cause those votes not to be cast. It is similar to just saying that the funds can't vote, but doesn't disenfranchise people who really want to vote and still gives all those shares the index funds own possible power.
I feel like the anti-competitive concerns about index funds are another example of people having concerns about everything and its opposite and not seeing that implies the problem is misidentified.
We're all worried about companies doing things to compete that are not in the interest of society, right? Less competition equals less (fewer?) externalities. Why even have companies in the first place if competition is simply always a good thing? Why was Eddie Lampert's clashing departments at Sears (supposedly) a disaster?
Ya you're right. I guess the correct solution then is to prevent index funds from voting entirely. If you own a company as a part of a passive vehicle, your vote doesn't count.
You don't. If you give a fund manager your money they are fiduciaries to you and the entire fund. They have to vote in a way that maximizes value for everyone.
I remember trying to build just this solution about a dozen years ago - the SWIFT integration was achievable but the main stumbling block was it seemed like a marketplace buildout - you needed to get everyone persuaded it was a good idea before it takes off.
> The extremely simple and correct solution here is to not let index funds themselves vote. Only allow the votes to be cast directly by the index share holders. Problem solved, I don't know why people keep hand wringing about this and not suggesting the supremely obvious solution here.
Something like create a super-voting share class for active investors and regular stock for the index funds?
An interesting idea, but not appropriate in this instance. Super-voting stock are basically a polite way of retaining control while not appearing to own a majority of shares.
They don't preserve the right incentive structure and remove escape valves the regular stock holders should enjoy. I thought the original idea here is to let the index investors direct the fund how to vote with their portion of the index's stock. A pretty neat idea that de-fangs much of the incentive risk if the index fund management goes rogue or an activist investor tries something.
More precisely, it might be simple but not easy: it’ll be quite difficult an operation to collect votes from the tens of thousands of shareholders of the funds, and votes are happening all the time on a global scale.
I think at some point we'll hit a saturation point on passively managed funds. What they're really doing is edging out the non profitable actively managed funds, and forcing managers to prove they can beat the market if they want investment. I also think we'll see more brokerages starting their own indices, which will lessen the power of any individual fund
Well think of it this way. Since index funds replicate the market exactly, then the non-index funds also on average replicate the market. It's just some funds beat the market while others underperform.
Isn't it possible for the index funds to simply not wield the power they have, and abstain from every vote? I was surprised that funds that are not actively managed are still actively engaging with public companies.
I don't know how votes are counted, but will that make it impossible to make positive changes?
Or if they are not part of the total count, allow a minority of shareholders to vote against the fund's interests?
> [W]ill that make it impossible to make positive changes?
Yes, but that's consistent with the passive philosophy at the heart of index investing. I was surprised that index funds had an active interest in anything beyond reducing fees to customers.
No. The point of owning a share is that you own part of a business. But, functionally, this isn't what index funds are doing. They employ next to no-one with any actual investment ability (from what I have seen, they employ an unusually high number of people with political connections/bank "product" types).
The problem is that this isn't really what the stock market is for. It has been turned into this infinite liquidity machine where ownership churns rapidly when the "point" is owning a business, stewardship of your asset, slow turnover (there isn't an easy solution because this is largely a supply situation, if you create a savings system that is based on the value of the stock market...it is hard not to end up here).
Btw, the issue with corporate governance is far broader than this too. Even before index funds, the system was totally fucked. You had boards stocked full of know-nothings with no stake in the company. Managers were already totally unaccountable, now even more so (this is why activism is taking off, the level of corporate waste/overpaying for executives is staggering).
This is such a fascinating problem. On the one hand Jack Bogle's invention of the index fund has been so good for retail investors but because the process currently requires a middle man - i.e. one of the big three - these index funds have slowly become bloated with power.
What if the algorithm Vanguard uses was open sourced and could be self-hosted by independent investors?
Where each investor owns their portfolio outright and adjustments to the portfolio are made automatically by a free index manager bot that runs the simple algorithm an index fund manager like Vanguard would.
> What if the algorithm Vanguard uses was open sourced and could be self-hosted by independent investors?
It already is "open sourced". Vanguard precisely discloses what's in each of their funds already [0].
The issue with independent investors perfectly replicating the securities underlying the index funds is that the vast majority of investors simply don't have enough capital to replicate the underlying components of the fund. Meaning, the typical investment amount of a randomly chosen investor cannot buy enough shares in proportion to each other to be as diversified as a massive $100+ billion fund. That's before discussing the issues with maintaining a balanced portfolio.
> Where each investor owns their portfolio outright and adjustments to the portfolio are made automatically by a free index manager bot that runs the simple algorithm an index fund manager like Vanguard would.
If you had enough capital and trusted such a bot enough, it's not hard. But the vast majority of people will never have enough capital.
Presumably if you replicate the holdings you are lagging their buys and sells. The lag could cost more than the fees so you might as well but the fund instead of replicating...
With free trades (now in everywhere) and fractional share purchases(robinhood), I think buying your own S&P500 fund would be possible with little capital ($1000?), and easy if your broker set up the software on their system to do that. I would not be surprised if robinhood already has this feature.
Why not just buy SPY? The expense ratio is only 0.09% and it's one security to track.
Given $1000 to invest, I can't fathom trying to individually own an average of $2 worth of each of 500 companies. And that doesn't even begin to cover it. Because the S&P 500 is market cap weighted, you would need to own $45.70 of AAPL, the top company. I don't know what the 500th stock is, but you'd probably need to own about $0.10 of it.
Even if trades themselves are "free", you still need to pay something like $0.13 per trade in SEC fees. So you are paying about a 100% commission on each of the smallest stocks you buy. And then another 100% commission when those stocks fall out of the index and you sell.
Just buy SPY. There are many good reasons that it has grown to $307 billion in net assets.
There are robo advisors who will buy the individual securities in indices for you, as long as you have enough invested with them (50k? I forget). But the only advantage over simply buying the fund AFAIK is being able to tax loss harvest from the higher volatility of individual securities. Eg, if your two-security index has stock A go down 5% and stock B go up 6%,an index fund would simoly go up 1% while the actual basket would allow harvesting the losses from stock A.
As far as I can tell, this is a fairly minor advantage, and if I wasn't using a robo-advisor, i certainly wouldn't be managing the basket directly just for this ability.
I think there are a handful of problems with this post, one of them being that index funds are already in many ways "open source." Re: their investment choices the investments that go into an index are chosen by the creator of the index which is separate from the investment house. The investment company MUST simply follow the index and trade as the index indicates. The tracking accuracy may vary slightly between Vanguard, Blackrock, and others, but generally they're all tracking accurately using basically the same methods. Any investor can move their shares to any other investment house at any time.
Also each investor already owns their portfolio outright... it is simply housed at the investment company. There is an absolute avalanche of regulation making that not just desirable but necessary. To remove a brokerage house from this equation would first require the complete and utter destruction of the global economic system (highly unlikely).
Every investor has the ability to choose funds crafted based on moral guidance or active management, which would spread out voting power more than it currently is. People are by and large not choosing that option at the moment.
Isn’t one of the concerns that index funds are supposed to mimic the index’s returns, but absolutely aren’t required to track the index holdings?
If absolute rebalancing was required in an S&P 500 index fund, there would not be enough liquidity in the market for some of the smaller of the 500.
It’s all been fine and well during a bull market, but a concern is that “index” funds have huge amounts of synthetic holdings that are untested in a rout.
The average investor’s portfolio wouldn’t be large enough for them “self host” their own index fund. Most people probably couldn’t afford to buy even 1 share of each of the underlying companies their index fund holds. There’s also a lot of work/judgment calls that are made in the rebalance process and with corporate actions and such. Granted, not nearly enough to justify most of the fees. But unfortunately (as it stands right now at least) the only way the index fund really works for retail investors is by way of pooling money.
All that being said, I’m optimistic someone can come along and find a way to shake the industry up. The status quo is great for the investment industry and pretty shit for everyone else. Tale as old as time.
The actual mechanics of owning the shares is incredibly complicated. It’s unlikely that any of us have index fund holdings that represent integer share counts.
Handling stocks when they move in and of the index without spiking the price is a finely calibrated, high skill trading desk action.
There are huge economies of scale in finance as well. The time it would require you to maintain the index would most likely cost you more than the management fee on the index.
Your brokerage software could make this easy. E-Trade could have a feature where you can buy/sell the S&P500, Russel2000, or total US index. You put in the total amount to invest and it does the rest.
That's obviously not what the parent comment is talking about, since they're holding it in contrast to index funds. They're talking about directly holding the securities involved.
Roboadvisors do actually offer this if you have enough money. The only advantage AFAIK is being able to tax loss harvest the greater volatility from individual securities.
Fractional shares are synthetic, so you can't vote them. At that point the way to do it is to have an index fund with bylaws that it votes shares as the members want.
It is "open sourced"...you can go to any index provider, and they will tell you what is in the index...you realise that there is no complex "algorithm", it is just a market-cap weighted index (and even then, you can replicate the perf of these indexes with 10-20 stocks).
And this has already been invented. It is called hub-and-spoke, you generally see this with small CTAs and the like where there is a central portfolio with trades mirrored into separate accounts...it works but it is unnecessary, and costly. Another example of is are those awful portfolio mirroring services (eToro is one I think).
Btw, the thing that you are saying is "free" is where all the cost is. Yes, it would be great if everything was just "free" and people would do things for me for no money...but that isn't realistic. Some companies do just provide the "investment" side without all the low-level trading/account management/customer-facing stuff but it usually isn't attractive to do so for individual investors...this is basically what the big pension fund consultants do.
Marketing to individual investors is utterly hellish. It is expensive and the money you obtain is usually pretty worthless. If you are actually have investment talent, it is a terrible financial decision. You can spend hours pitching for pocket change with retail investors or you can make the same in a few seconds with an institution.
Wow! Thanks for all the replies. Glad other people found this silly idea interesting.
A lot of the issues that were brought up have to do with fees associated with purchasing all the stocks and the fact that you would have to buy very small fractional shares. Certainly big issues today but they don't sound like showstopper problems to me.
And to the folks criticizing my lazy use of the term "open source" - I apologize. I should know better using that phrase on hacker news!
To clarify: clearly the market weighted index process is a well known and very simple algorithm. What I meant by "open source" was a tool that can employ that market weighting process and handle all of the financial transactions necessary to execute all of the trades.
I think the problem with this would be brokerage fees for buying/selling. If a fund is rebalancing 10% of their holdings the fees are a rounding error, if I'm rebalancing 10% of mine as an individual the fees would be a noticeable percentage.
One reason is because an individual investor has to go through a broker-dealer in order to trade and that usually has fees associated with it. If retail trade volume went up, you would see those fees rise.
Having spoken with few people, the process is still mostly people, building algorithms in Excel.
Much of what drives decisions is research, and personal decision's, not automation.
I've heard AI trading has done very poorly as the system isn't predictable, it's people making decisions in ways which can become self fulfilling prophesies.
Algorithms when distributed would also fall victim to the fastest person benefiting the most
An index fund isn't doing research or making decisions though.
They invest in companies that make up an index. When a company enters the index they buy units in that company, when a company leaves the index they sell those units.
While this seems (incredibly) scary it makes me think that this could be a huge opportunity for entrepreneurs (and some are currently undertaking it).
The fintech entrepreneur can carefully paint the picture of the dangers of the big 3 while advocating for smaller index funds for a smaller set of investors.
This smaller set of investors can have stocks based on their individual goals and interests. You just duplicate this over a lot more funds. The returns won’t be as high initially but if the entrepreneur can convince customers that this must be done it should help spurn new markets towards sustainability or carbon reduction etc.
Edit: plz tell me if I totally misunderstood the article.
You just described M1 Finance (custom funds users can construct). Google Warren Buffett’s Long Bet about passive vs active fund management (he won the passive argument). Even sophisticated active investors are having a tremendously difficult time achieving passive returns net fees. If you’re not a sophisticated investor, I’d implore you to be cognizant of the challenges you’ll face attempting active investment strategies, especially if you’re investing retirement funds.
Passive index investing might not be perfect, but it seems to be the least worst option when evaluating fund costs and risk adjusted returns, and we’re aways off from significant second order effects.
There are other use cases than returns, sometimes it has to do with availability of funds or tax issues that constrain the possibilities. Even something as simple as the full spectrum of risk tolerances and time-horizons isn't well served by existing index retirement funds (they all skew to be highly risky and equity focused). It's better to have the running of an index fund be a separate service from the selection of its holdings or the choosing of goals. Right now if you have a slightly different goal than the horde, you can only go to expensive active funds, advisors, or spend a great deal of time self-managing.
I think the opportunity lies in the other direction. Say that fund managers for index funds aren’t generally accountable for performance (assuming they actually comply with the index. Differentiate the funds on their voting strategy. I don’t really give a crap about my investments if they’re well diversified across large US companies. But I would 100% prefer a fund that promised to vote for climate and civil rights issues.
> Index funds “are great for investors,” says Elhauge, “but part of the reason they’re great for investors is exactly because of the anti-competitive effects.” Elhauge says the trusts of the late 19th century that gave rise to today’s antitrust laws also involved a form of common shareholding.
> She might want Coca-Cola to take big risks to crush Pepsi, and invest capital in new products and markets to do so. An investor who holds both, on the other hand, would prefer that Coke and Pepsi avoid price wars.
So the way we can solve this problem is to outlaw shares ownership of competing companies? Seems like a fair solution.
> So the way we can solve this problem is to outlaw shares ownership of competing companies? Seems like a fair solution.
This just isn't practical. What if I'm invested in Big Bank and Big Tech Co. but then Big Tech Co. creates a wallet app and credit card -- do I have to sell my ownership in one of these companies?
As an investor I definitely want to own companies that compete because I don't know which one is going to prevail. Owning just one of the companies doesn't really fix the problem either -- if I own only Pepsi does that mean I would want them to get into a price war with Coke?
> do I have to sell my ownership in one of these companies?
No, company would have to split itself (create separated business entity) so you would have to sell your competing part of the company.
Such a change can also solve problem of companies using their dominant/monopolistic position in one business area to get unfair advantage in another.
> As an investor I definitely want to own companies that compete because I don't know which one is going to prevail.
That's the problem article describes! Such behavior reduces competition and hurts customers:
>> This line of research began with a 2014 paper about competition among U.S. airlines that quietly shook the fund industry and the antitrust world. José Azar, an economist at the University of Navarra in Barcelona, along with Martin Schmalz and Isabel Tecu, showed that airline ticket prices were 3% to 7% higher because big funds owned stakes in so many airlines.
> No, company would have to split itself (create separated business entity) so you would have to sell your competing part of the company.
How about categories that aren't cut and dry? Lets say the tech company develops an AI tool that banks could apply to track delinquent accounts. And a bank develops a regular tool to do the same? Is this something that warrants splitting your business? Do both split or just one of them? which one?
How do you police this? What about small companies? What about international companies? What about public funds that hold a bunch of companies?
I'm sorry but while there is clearly a problem to be solved, what you proposed is definitely not the solution.
No, it's actually pretty much the selling point that Apple the phone manufacturer is also Apple the security chip manufacturer, Apple the OS development company, Apple the financial services company, and Apple the company that supplies the wallet app. This means that I only have to trust one entity to use Apple Pay to buy things with my phone. This largely collapses if Apple can't at the same time be a manufacturer of chips, a seller of phones, a developer of operating systems, a provider of applications, and a handler of financial transactions.
This is sort of meaningless use of the term, like saying every company is an electricity company or a paper company. Every company's _inputs_ are growing to include tech, but their outputs aren't: a company making tractor wheels or cans of soda is by no measure a tech company in the context of this conversation.
I absolutely agree. If you could only invest in one tech company, who would have invested in Apple/Amazon/Google instead of IBM? These are now large, successful companies that were able to succeed because investors were able to hedge and invest in an entire sector.
> If you could only invest in one tech company, who would have invested in Apple/Amazon/Google instead of IBM?
IMHO there shouldn't be Apple/Amazon/Google/IBM companies as they are today. I want Google and other companies be splitted to AdWords, GoogleSearch, YouTube, Android, Waymo companies. And they should not use their dominant/monopolistic position in search/ads areas to get unfair advantage in other areas.
So you would have to choose your investment between Android/Apple/WinMobile OS, AdWords/AdMob ads, Waymo/Cruise cars, Google/Yahoo/DuckDuckGo search, YouTube/Vimeo videos.
Including DuckDuckGo in your list of search companies exposes one of core issues that makes this idea unworkable. DuckDuckGo is basically just a skin that shells out to Bing, Yandex, or Google.
Is it? Article says that it can be bad for customers:
>> José Azar, an economist at the University of Navarra in Barcelona, along with Martin Schmalz and Isabel Tecu, showed that airline ticket prices were 3% to 7% higher because big funds owned stakes in so many airlines.
What if I believe that the overall market for cola beverages will increase but don't want to place a bet on a specific company? In that case it makes sense to buy both Coke and Pepsi.
> So the way we can solve this problem is to outlaw shares ownership of competing companies? Seems like a fair solution.
Your suggestion is for people to take big risks and put all their eggs in a few baskets. Not only is this totally opposed to why people make multiple investments, but doing so could make the market more volatile because any fluctuation or current event could encourage people to suddenly "switch sides".
> She might want Coca-Cola to take big risks to crush Pepsi, and invest capital in new products and markets to do so. An investor who holds both, on the other hand, would prefer that Coke and Pepsi avoid price wars.
> So the way we can solve this problem is to outlaw shares ownership of competing companies? Seems like a fair solution.
Nobody cares about Pepsi and Coca-Cola. Coca-Cola and Apple aren't competing, so if Coca-Cola can somehow be in the same index as Apple, and Apple gets 2x the return as Coca-Cola (which it does), which is what really makes the index look good against an average active picker (who doesn't pick Apple), it's a moot point who's allowed to own which shares in competing companies.
There are two real stories about indices. The first is [1] -- sorting the huge individual winners into different indices so that crappy companies, like Comcast and AT&T, can ride up on the demand for the index they are part of. Then there's [2] -- that most demand for individual stocks is the corporations themselves.
When you buy an individual stock versus an index with that stock, you're really making two bets: (1) a bet that there are an excess of individual stock pickers for this stock than for the indices it is part of, and (2) a bet on how much cash a company can get from consumers (even if it is a B2B company) to spend on buybacks in the long term. When you buy the index, you are betting that an industry or corporate class (e.g. large cap companies) are going to sort winners into the index more favorably and claim large amounts of consumer cash from outside that industry / low camp & mid cap stocks. [3]
There are negative trending industries! See S&P Oil and Gas Exploration. The article is talking about Coca-Cola and Pepsi, which do not create new products, they are marketing companies, it isn't about prices at all for them, it is such an utterly dumb example. She should be talking about two fracking companies, whose stock performance is extremely sensitive to oil prices.
The opposite of what the article thinks is happening: people are exiting common ownership of the companies (e.g. the S&P Oil and Gas Exploration index) that, as common owners, they have the most to gain from anti-trust (e.g. agreeing on a price for gas and oil).
I think there’s a bigger issue with passive inversing. Once an equity is in a cap weighted index like the S&P 500 with a high weighting, like Apple, can’t we end up in a situation where the individual company performance is irrelevant? Nobody will sell Apple because they just own it through their SP500 fund. As long as they are buying and holding the index fund, Apple remains at a high valuation. The only thing that differentiates individual stocks is active investors. And as they make up a smaller and smaller fraction of over investment, they become less relevant.
And as active investors become less relevant in the market, their returns will increase bringing the situation back into balance. Dumb money gets fleeced.
I don't think it'd be much of a concern at a larger scale either. I stopped actively investing a long time ago because it wasn't worth my time, but if the market got to the point where it was responsive to reality, the increased returns would probably draw me back in. And before me would be institutional investors, picking up ~free returns. The system is designed to be self-equilibriating in this respect
That is one of the problems if you have to hold share for example Enron because you track the index you have to hold it all the way down.
For a personal example from the UK one of my actively managed investment trusts sold out of banks before most of the share price crash happened a few years ago.
