Active money management has lost its luster. Since the Great Recession, investors have given up on expensive hedge funds and their mediocre returns, preferring far less flashy options like index funds. Even after years of loose monetary policies and low volatility, weary investors are hesitant to jump back into the fray of active investing. Passive investing in index funds is now the new normal for the stock market. If investors want to see companies return to innovation and long-term growth, they should hope it stays that way.
Passive investing holds promise as a key tool in the fight against an increasingly common issue: corporate short-termism. Measuring data for publicly traded companies from 2001 to 2015, a McKinsey report found a significant, upwards trend in short-term thinking by corporations. For public companies, short-termism typically takes the form of share buybacks. Rather than reinvesting profits in new projects, these companies use the money to buy shares from their investors to boost their stock prices. As a result, short-term companies invest less in innovation and, according to the same McKinsey report, experience lower earnings growth than companies with long-term strategies.
Company executives cite pressure from investors, arising from increased media coverage and lower trading costs, as one of the main reasons for their short-term thinking. Index funds offer insulation from these pressures, allowing corporate executives to worry less about volatile investor reactions and focus instead on long-term growth. Index fund investors focus on the performance of the fund as whole, and the diverse companies that make up these funds dilute the impact of any one company’s stock fluctuations. Because of this, missed quarterly earnings face less scrutiny when many investors are only looking at the performance of the index and not the individual stocks it is comprised of.
Furthermore, for the casual investor, index funds are typically part of a hands-off investing strategy, again offering more leeway for companies to pursue long-term growth. Individual investors increasingly recognize that neither day trading nor actively managed funds are likely to outperform stock indexes over the long term. In response, these investors rely more on diversified index funds, offering better returns and peace of mind. This means fewer stockholders scrutinizing the performance of individual companies, leaving fewer people to exacerbate price changes by jumping into the dangerous strategy of buying rising stocks and selling falling ones. Thus, index fund investors escape the dreaded “buy high, sell low” scenario that plagues traders of individual stocks, while corporations avoid the volatility that accompanies this positive feedback loop.
However, index funds do not erase volatility altogether, especially when one considers that not all index funds investors are so passive. In fact, trading data for a type of index fund known as an exchange-traded fund (ETF) indicates higher volatility for stocks making up ETFs due to the low trading costs of these funds. Importantly, though, this increased trading can largely be considered “noise,” not tied to market fundamentals of individual stocks. Because of this, individual companies’ actions have little effect on this volatility, still allowing executives to pursue long-term projects with less pressure from myopic investors.
By moderating investor pressure to meet short-term expectations, the popularity of index funds grants corporations more freedom to invest in innovation, even when these projects take time to turn a profit. Because most project expenses are immediate while resultant increases in revenue may take time to materialize, investments in innovation often fall prey to shortsighted expectations for a company’s bottom line. Other companies avoid investing in innovation due to the uncertainty of success, weighed against the investor backlash if they fail. If companies expect an outsized impact on their stock performance should a project prove unprofitable, otherwise-promising investment opportunities go unrealized. In either case, companies can invest more in innovation as more projects become worthwhile when given enough time to overcome the costs of the initial investment.
Some critics of index funds charge that rather than promoting innovation, the popularity of index funds instead encourages monopolization and other anti-competitive practices. Supposedly, index fund managers use their large ownership stakes of companies within the same industries to discourage competition and raise prices. As a recent piece from The Atlantic highlighted, though, fund managers can only offer their low-cost index funds by avoiding costs of highly active management. Thus, the coordination required to design and enforce anticompetitive efforts on such a large scale would prove prohibitively expensive for these index fund managers.
Furthermore, in instances where index fund managers do exercise their voting power, they typically do so in ways that support long-term company performance. In August 2017, Vanguard voted against ExxonMobil’s management to require disclosure of climate change risks. In the long-term, this increased transparency will help the company, boosting its reputation for honesty and encouraging it to adapt to the climate risks it will face. For Blackrock, issues over executive compensation make up the largest proportion of its votes against management. Both of these asset managers are willing to exert their influence to encourage long-term thinking in the companies they hold, largely because it is long-term performance that index funds’ customers seek.
These criticisms do raise another valid concern over the rise of index funds. While freedom from excessive investor scrutiny can encourage companies to pursue innovative projects, it can also allow corporate executives to engage in dubious business practices with fewer repercussions. Investors play a key role in disciplining C-suite executives through company votes, but this threat is only credible if investors catch wrongdoing in the first place. As large shareholders, index fund managers should remain vigilant of wrongdoing, monitoring companies on their own or heeding the warnings of activist investors.
The popularity of index funds has eased some of the pressure restraining corporate investment in long-term growth, but it is still up to index fund managers to ensure company executives use this freedom to enrich their investors, not to line their own pockets.