One of Warren Buffett’s favorite bits of advice to the average person is for them to invest a dollar amount each month into a passive index tracker fund. The wisdom behind it is simple – the average mutual fund manager under-performs the index and the average person can’t separate the great managers from the poor. Collectively, people can only do as well as the stock market index minus management fees, so it makes sense to minimize the fees.
The advice seems to have finally sunk in, the proportion of assets in passive funds has almost doubled in the last 10 years and now stands at 21% in the USA. That is projected to keep rocketing over the next 10 years.
The movement to passive seems to have its own online army as well, message boards are now full of people that will recommend index funds to all who ask for help investing, and when challenged will link to one of many statistical papers that proves the average investor does better in index funds than actively managed funds. You can’t argue with statistics can you.
We value investors like to think we have what it takes to separate the wheat from the chaff, with individual stocks as well as money managers. But we can never escape the fact that if everyone did as we did, our returns would all be average.
Shareholder Apathy
But it is becoming obvious to me, that this liberation of the people from the oppression of greedy fund managers is coming at a cost – to shareholder power and activism. It is one component of what has been a greater shift towards shareholder apathy. An index manager balancing his portfolio does not care about individual holdings, he is not paid to and has no incentive to. As Charlie Munger would say, you can predict how people act and why they act just by looking at the incentives.
And with more shareholders taking little interest in governance, too many boards of directors are sitting comfortably in the knowledge shareholders will have a difficult time trying to mobilize against them.
Many fund managers (both active and passive) these days hire a firm to vote for their shares. These firms are supposed to be experts in directorship and effective management, yet they are all too often more focused on ticking boxes on a checklist and keeping the peace than what is good for shareholders. Have a read of the FMCO annual letter for case in point.
The USA is lucky in that shareholder activism is still alive, though far from thriving. Other countries like the UK have little to no shareholder activists, or what the press would refer to as ‘corporate raiders’, that will prey on the poorly managed companies and stir up the directors.
People may dislike how people like Carl Icahn operate and make money, but roles like his are vital to keeping the market efficient and fair for shareholders.
So consider how much more difficult it is for a shareholder to gather the votes to influence the board when 21% of those votes are with passive managers that do not care and whose votes are dictated by one of the few ‘proxy advisers’. These advisers hold no stock themselves and it isn’t clear whether their fees have any performance related element. They also appear to be particularly averse to confrontation, this quote is from Institutional Shareholder Services, a unit of indexer MSCI
“Negotiations enabled boards to curtail contentious contests at high-profile targets, to repel repeat rows over shareholder resolutions or executive pay, and to dodge very public debates with activists over strategic direction.”
These aren’t the qualities I would hope to see from someone responsible for my votes. When it comes to boards, I don’t want to focus on ‘not making a fuss’, they should follow the wishes of the shareholders – if these are misguided then the board should be able to give a convincing argument why and resolve the issue.
Some boards simply wring the company for everything they can – think Dan Loeb and the Sotheby’s situation. In these cases I don’t want to send in a sheep dog to try and herd the board, I’d rather send in a pit bull terrier.
Investing Sidekick
Founder of Investing Sidekick. Works as a research analyst and is an avid value investor, always searching for undervalued shares.
You bring up an interesting point. I have been thinking a lot about the implications of the rising trends of pseudo passive investing and ETFs. Being in a ETF can create a sustained buying or selling pressure on a stock and might lead to value distortions. Another way to generate alpha.
Indeed, in fact Joel Greenblatt in his book ‘How to be a Stock Market Genius’ says that he looked for spin off situations where the spun off company would be too small for the index and hence all the index funds would immediately sell the shares. Creates a lot of selling pressure hence price drops leading to better bargains for everyone else.
As more and more people pile into index funds, does the market become less efficient? When you buy an index fund, it affects the price of the stocks it holds. How can the price of the stock be a reflection of all available data when it is held through an index fund?
I think as passive investing becomes more popular, it will actually make active investing more attractive. The index funds will exacerbate market inefficiencies and active managers will be able to take advantage of this.
Think about it this way, if 100% of the market was held by index funds, it could not possibly be efficient, as the price of any given stock would not be based of any company specific information.
You mentioned shareholder activism in the US vs say the UK. A bit of context should be illuminating.
My understanding is that the UK, for instance, has much more friendly shareholder laws vs the US.
Here is an interpretation of shareholder activism to think about: activists specialize in scaling the 10 foot hurdles that obstruct shareholder rights in the US, and via this specialized skillset, they reduce agency costs, which ultimately increases expected payouts to shareholders, pushing up stock prices in the process.
If you live in a country where the hurdles are only 1 foot tall, not 10 feet tall, would you really expect people to make a living specializing in scaling those hurdles? Stepping over 1 foot hurdles is hardly a difficult skill to replicate / develop. Scaling 10 foot or 100 foot hurdles, on the other hand, is quite difficult to replicate.
Similarly what kind of behavior would you expect from a management team that is insulated only by 1 foot hurdles? If such a management team does shareholders a major disservice, the stockholders can pretty easily scale the hurdles and retaliate. Management would anticipate such retaliation and generally engage in less agency cost related activities from the get go. What kind of activities would you expect from Managements insulated by 10 or 100 foot hurdles?
Very interesting take on it, I definitely think that board room excess is less of a problem in the UK than the US, and we don’t have things like the dreaded poison pill to protect directors.
Not sure if that is due to better shareholder rights or just a reflection on the difference in societies.