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Beware of Index Funds' Dominance: Author

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Passive investing is “a big animal” in the market ecosystem, eating other animals that need to change their behavior. “That’s having ripple effects on the entire financial industry,” argues Robin Wigglesworth, global finance correspondent for the Financial Times, in an interview with ThinkAdvisor.

His new book, “Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever” (Portfolio/Penguin, Oct. 12), has been proclaimed “a tour de force” by Mohamed El-Erian, president of Queens’ College, Cambridge, and chief economic advisor at Allianz.

Wigglesworth considers the growth of passive investing “one of the most consequential challenges to the way capitalism functions that we face in the coming decades.”

The big three index fund providers are BlackRock, Vanguard and State Street, which have more than $20 trillion in index funds under management.

Wigglesworth is concerned that the chief index fund providers will “keep getting bigger until there will be just a handful of big asset managers that, in practice, control the majority of the voting shares of most major companies, both in the U.S. and overseas.”

Wells Fargo launched the first index fund in 1971, which was actually a small account rather than a fund, per se, according to Wigglesworth. It was open only to institutional investing.

Five years later, John Bogle, at his newly formed firm, Vanguard, introduced the first index fund for retail investors.

In the interview, Wigglesworth predicts “a vibrant future” for active exchange-traded funds and foresees a growing number of mutual funds that will be converted into active ETFs.

With their “Lego-like characteristics,” ETFs are “reshaping finance,” he says. “You can put anything into an ETF structure,” including gold and Bitcoin.

Direct indexing, within so-called Index Investing 3.0, will be a trillion-dollar industry within 10 years and “an important and powerful tool for a lot of financial advisors,” he predicts.

At first, people dismissed the index fund, laughing at such a “preposterous” idea, Wigglesworth says.

One active investment manager even created and circulated a poster blaring: “Stamp Out Index Funds!” They’re “Unamerican!” It wasn’t long before index investing was “vitriolically” attacked, says Wigglesworth, who focuses on big trends transforming markets and investing.

Previously, he was the Financial Times’ U.S. markets editor. Before joining the paper in 2008, he was with Bloomberg News.

ThinkAdvisor recently interviewed Wigglesworth, who was speaking by phone from Norway, where he’s based. When the conversation shifted to shareholder pressure for companies to focus more on ESG investing, he called the issue “potentially problematic and dangerous.” Then he went on to tell why.

Here are highlights of our interview:

THINKADVISOR: Why will “the growth of passive investing prove to be one of the most consequential challenges to the way capitalism functions that we face in the coming decades,” as you write?

ROBIN WIGGLESWORTH: It’s changing the nature of financial markets and how they function, and that’s having ripple effects on the entire financial industry.

It’s a big animal in the market ecosystem eating other animals that are needing to change their behavior.

So if you’re an investment bank, like Goldman Sachs or Bank of America Merrill Lynch, you have to fundamentally retool what you do and how you do it in a world where passive is the largest part of the investment universe and growing more rapidly than anything else.

The big index fund [providers] will keep getting bigger until there will be just a handful of big asset managers that, in practice, control the majority of the voting shares of most major companies, both in the U.S. and overseas.

“The debate over the impact of index funds will undoubtedly grow in the coming years,” you write. Why?

Because investment groups are under increasing pressure from many different areas to use their talent for “good.”

Shareholders are putting pressure on every major company in the world to [focus] more on social issues or the environment or corruption.

This is potentially problematic and dangerous given that these are fundamentally private companies managing other people’s money and cannot escape the pressure groups that come from both left and right.

There’s a phenomenal concentration of power in BlackRock, Vanguard and State Street, which have over $20 trillion worth of index funds under management.

If they continue to grow at their current rate, they’ll attract political and regulatory scrutiny, as well as scrutiny from all sorts of interest groups as a way to leverage their views.

Does ESG investing fit in here?

Yes, ESG is a prime example of this. The asset managers are under immense pressure to do more on ESG.

You can see the beginning of a backlash from some politicians; for example, [Sen.] Marco Rubio [R-Fla.] and [Sen.] Ted Cruz [R-Texas] have recently spoken out about what they call “woke capitalists” and that BlackRock and Vanguard shouldn’t be trying to de facto legislate on issues such as climate change or social change.

You write that direct indexing may be the next stage of “Index Investing: 3.0.” Please discuss.

It seems that everybody is getting into direct indexing right now — we all want a bit more customization in our lives, and direct indexing is sort of the incarnation of that in index funds.

In the next five to 10 years, direct indexing will be a trillion-dollar industry easily, but I don’t think it’s ever going to rival the ETF market or index funds. It will grow quickly, but won’t be as big as its main rivals, Indexing 1.0 and Indexing 2.0.

Direct indexing will be an important and powerful tool for a lot of financial advisors, but on scale, I doubt it will ever compete with plain vanilla index funds and ETFs.

More on this topic

Why not?

Direct indexing is sort of blurring the line between passive and active — the line has always been quite blurry anyway — and direct indexing will wipe out that line [further].

But most people still want simplicity and don’t want to fiddle around with individual stock holdings and a list of 500 securities.

You write that ETFs are “now reshaping finance thanks to their Lego-like characteristics.” Please elaborate.

Sometimes we think of the ETF as a purely passive fund because that was its genesis, but it has a structure that’s actually far more flexible and powerful.

The ETF allows you to build essentially any sort of fund that you want and trade on an exchange. You can put anything into an ETF structure, whether active strategies — such as Cathie Wood’s Ark Invest — or far more complicated passive strategies. You can put in bonds or derivatives or gold.

You can now even put Bitcoins in there.

So a financial advisor can assemble a far more complicated and, hopefully, far better portfolio than with the more rudimentary building blocks they had at their disposal even just l0 years ago.

What did Dimensional Fund Advisors bring to the indexing party?

They were among the very first to realize that you can do an index fund in many different ways. The first generation of index funds was overwhelmingly large-cap U.S. equities.

David Booth of Dimensional saw an opening to not only offer greater diversification for a pension plan, say, but that small caps also tend to do better in the long run. And so he set up Dimensional initially with eight small-cap passive funds.

They built from there and started doing index funds of different flavors — value index funds, overseas small-cap index funds [and so on].

They had a tactical role in the index revolution and also a role in helping to popularize those ideas to the advisor community — which, after all, is the main interface between Wall Street and Main Street.

John Bogle created the first index fund available to retail investors. But he wasn’t a fan of ETFs, was he?

He hated ETFs because he feared they would lead to overtrading. He thought of ETFs as the ultimate Purdey gun: People can put in very complicated derivatives that can blow up ordinary investors without them realizing how and why.

That was what he was worried about.

But he could see that because ETFs were easy to buy, they were helping to [expand] the indexing revolution and the low-cost revolution far broader than just the plain vanilla index mutual fund.

So he softened [his stance] on ETFs a little. But he was always concerned, up to pretty much his dying breath, I guess, that people would still overtrade them and put dumb stuff into them.

Talk about the rising influence of index providers (as differentiated from “index fund providers”).

It’s the untold story of the rise of passive investing. Lots of attention is paid to the big three: BlackRock, Vanguard and State Street.

But for the vast majority of the money they control, in index funds, at least, they don’t make the decisions as to where the money goes. Index providers do that — the people who create the index.

And that has its own big three: S&P Dow Jones Indices, MSCI and FTSE Russell. They’re incredibly influential because they set the benchmark for all active managers.

Some academics think that the index providers’ power has reached the point where they enjoy almost quasi-regulatory power over the equity market in America and abroad just given their influence over all these passive dollars.

Yet you write that “there are signs that the index funds launch bonanza is slowing down.” Is that happening?

Yes, in some areas. For a long time, people just threw stuff up on the wall [dubbed the "spaghetti cannon" approach] and saw what stuck. Suddenly, something captures the zeitgeist and is incredibly profitable.

But the period of immense product proliferation is now approaching the end, at least in the equity world. The innovation is slowing and will slow further, though there will always be new passive strategies that people will invent.

This doesn’t mean we won’t see more “spaghetti cannon” product launches in areas like fixed income or commodities and certainly active strategies, such as Ark Invest.

So what’s the future of active indexing?

It think it has a vibrant future in ETFs. As a structure, ETFs have some advantages over mutual funds that help with distribution. So that makes some of the distribution a little bit easier.

Also, in the U.S., the tax advantage is significant and is a huge tailwind.

So I expect we’ll see more existing active mutual funds converted into ETFs and more active strategies needed in the ETF format. For example, J.P. Morgan recently [announced it was] converting several billion dollars’ worth of active mutual funds into ETFs.

We’ll see far more of this [conversion] in the coming years [industrywide].