Criticism of index-tracking funds is ill-directed

By The Economist online…

INDEX funds were devised in the 1970s as a way of giving investors cheap, diversified portfolios. But they have only become very popular in the past decade. Last year more money flowed into “passive” funds (those tracking a benchmark like the S&P 500) than into “active” funds that try to pick the best stocks.

In any other industry, this would be universally welcomed as a sign that innovation was delivering cheaper products to the benefit of ordinary citizens. But the rise of index funds has provoked some fierce criticism.

Two stand out. One argues that passive investing is, in the phrase of analysts at Sanford C. Bernstein, “worse than Marxism”. A key role of the financial markets is to allocate capital to the most efficient companies. But index funds do not do this: they simply buy all the stocks that qualify for inclusion in a benchmark. Nor can index funds sell their stocks if they dislike the actions of the management. The long-term result will be bad for capitalism, opponents argue.

A second argument is that index funds pose a threat to competition. The asset-management industry used to be remarkably diverse. It was hard for any active manager to keep gaining market share; eventually, their performance took a hit. But passive managers benefit from economies of scale. The more funds they manage, the lower their fees can become, and the more attractive the product.

Since passive managers like BlackRock and Vanguard own the shares of every company in an industry, the fear is that they might play a role reminiscent of the monopoly “trusts” of the late 19th century. Studies have argued that the concentrated ownership of shares is associated with higher fares in the airline industry and fees in the banking sector.


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Category: Business and finance, Approved, Business and finance, Finance and economics

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