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A generation ago Jack Bogle invented the index fund. Now he's warning his creation may have a negative impact on the stock market.
Bogle, who founded The Vanguard Group in 1974, wrote Thursday in The Wall Street Journal that if current trends continue, index funds will soon own half of all U.S. stocks. He thinks that could lead to a dangerous vacuum in corporate governance – with nobody to effectively police the corporate executives who run America's largest companies.
"Public policy cannot ignore this growing dominance, and consider its impact on the financial markets, corporate governance, and regulation," he wrote. "These will be major issues in the coming era."
The 'Father of Index Funds'
Bogle founded the First Index Investment Trust, now the Vanguard 500 Index Fund, in late 1975. At first, Wall Street totally rejected the idea. The fund’s IPO the following year fell a whopping 95% short of its goal, raising only $11 million. Tracking a broad market index was a completely new strategy at the time and that unsurprisingly met with criticism, becoming known as “Bogle’s folly.”
Over the past few decades, however, indexing's popularity has soared. Holdings have trended steadily upwards, from 4.5% of total U.S. stock market value in 2002 to 9% by 2009. Stock index fund assets now total $4.6 trillion, and their overall percentage of total stock market value has almost doubled again in the last decade to 17%.
In the meantime, Bogle has become something of a folk hero. He has been praised by numerous finance gurus, not to mention the self-proclaimed 'Bogleheads,' who maintain a popular online personal finance forum and regularly hold local and national gatherings, where Bogle himself sometimes speaks, despite his advancing age. The 89-year-old was featured in Money's May 2017 cover story, in conversation with entrepreneur Tony Robbins.
Reshaping the Stock Market
Index funds' growth has had some unintended consequences. As Bogle points out, there are three index fund managers who dominate the field: Vanguard has a 51% share of the market, followed by BlackRock with 21%, and State Street Global with 9%. There are significant obstacles to becoming a major player, however, so it’s not likely any new competitors will reduce the huge concentration enjoyed by these big powerhouses. There's good news for investors: As competition between larger fund managers has increased, fund fees have gone way down. Fidelity offered several zero-cost index funds this year for instance, a clear sign that low price points will make it even harder for additional firms to create new funds.
While most economists expect the share of corporate ownership by index funds to increase further over the next decade, index mutual funds will no doubt rise above 50% of total market value – between 2021 and 2024, according to Moody's. That means the so-called ‘Big Three’ would own over 30% of the U.S. stock market, which Bogle says gives them effective control. “I do not believe that such concentration would serve the national interest.”
A New Problem on the Horizon
If historical patterns hold, index funds’ popularity could soon become a problem, Bogle argues. “A handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation.”
That might leave a power vacuum, leaving corporate chieftains unaccountable. CEOs who run companies supposed to answer to boards of directors, who are in turn elected by shareholders. Index funds are the biggest shareholders at most companies though. In theory, funds are supposed to vote their shares on behalf of their own investors – everyday workers who own fund shares in a 401(k) or IRA account. But there's a wrinkle: Index funds' investing strategy revolves around passively buying every stock in the market, while holding cost down as low as possible. The upshot is that they have little wherewithal or incentive to keep tabs on CEOs or other corporate managers.
Solving the Problem
Unfortunately, there’s not much that the average investor can do. Some funds, however, have tried to step up corporate governance. Earlier this year, BlackRock CEO Larry Fink penned a letter companies that BlackRock invests in, urging them to consider societal responsibilities. Sparking a debate on Wall Street for years to come, Fink emphasized that corporations should “serve a social purpose” and “benefit all of their stakeholders,” not just a select few.
But many observers argue funds fall far short, especially when it comes to issues like reining in runaway executive pay.