How Index Funds Are Hurting Investors and the Market

The increasing popularity of investing in passive index funds might be killing capitalism’s greatest engine of innovation—competition. Since 2010, actively managed funds have shrunk from comprising 75% of all fund assets to just 51%, as passively managed funds have grown to 49%. This trend could have “adverse consequences,” argues University of Chicago law school professor Eric Posner. At a recent investment conference, Posner expressed concern that the rising growth of passive investing and concentration of ownership of index funds is undermining competition, according to Barron’s. 

“The problem with common ownership in index funds is that you have institutional firms—BlackRock, Vanguard, State Street—become the biggest owners of companies like Ford and GM. It hurts these companies’ incentive to compete with each other, leads to higher prices and slower economic growth. That’s the theory,” he explained, according to ETF.com.

As firms compete amongst each other for a greater share of profits they have an incentive to innovate. By producing new innovative products for consumers they can distinguish themselves from competing firms, and by creating new innovative methods of production they can drive down their production costs and lower the prices at which they sell their goods in hopes of undercutting the competition. That is how competition is supposed to stimulate innovation and lower costs for consumers.

The problem that index funds, and specifically their concentration of ownership, pose to this engine of innovation is that it lessens the incentive for firms to compete. If traditional rivals such as Coke and Pepsi are owned by the same shareholders through an index fund, then there is less reason for the two soft-drink makers to compete with one another for a greater share of profits in the soft-drink market. With less incentive to compete, there is less incentive to innovate, hurting both customers and investors in the long run.

In just 20 years between 1995 and 2015, the proportion of companies that had the same large common owners grew from 20% to 80%, leading to a major concentration of ownership problem, according to Posner. Investors are obviously attracted to the low fees and high liquidity that big firms can offer precisely due to their scale. But this gives these big firms unprecedented control as it is their investment managers that act on behalf of their clients’ shareholder voting rights.  

Even the late Jack Bogle, legendary investor and creator of the very first index fund, expressed concern late last year about the high concentration of ownership that has resulted from the growth of index-fund investing. Bogle worried that if index funds ever owned half of the market, a point at which “The Big Three” index-fund firms—BlackRock, Vanguard, and State Street—could own as much of 30% of all U.S.-listed assets, then these firms would wield unprecedented power. 

Due to the potential adverse consequences that could come from such unprecedented power, Bogle argued that, “public policy cannot ignore this growing dominance, and consider its impact on the financial markets, corporate governance, and regulation.” Regulators may have heard Bogle’s call, as the SEC is now becoming concerned about the power of ‘the big three’ and examining the regulatory hurdlesthat are preventing smaller firms from being able to compete.