Will Concentration and Governance Issues Challenge Indexing Trend?

Investment advisory predicts key foundational issues could slow indexing trend among institutional investors and retirement plans.

By John Manganaro | May 01, 2015
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The fiduciary duty prescribed by the Employee Retirement Income Security Act (ERISA) mandates close attention for fee issues, so it’s no surprise low-cost index funds have grown in popularity among retirement plan sponsors and advisers.

Practitioners across the retirement plan industry are likely familiar with the positive features of index funds after years of increasing attention and use by institutional investors—generally lower fees and better transparency—but at least one advisory firm is urging investors to reconsider the wisdom of relying entirely on indexed products and portfolios.

The firm is Wintergreen Advisers, and while it is far from the first advisory firm to push back against purely passive investment strategies, its stance takes an interesting (if somewhat vitriolic) perspective on what makes overzealous indexing precarious. As the firm explains it, “The rush of money into index equity funds has officially ballooned into a market mania.”

This is the topline finding of a new analysis from Wintergreen, appropriately titled “How the Votes of Big Index Funds Feed CEO Greed and Put Americans’ Retirement Savings in Peril.” The research estimates that passive U.S. equity funds gathered an impressive $167 billion in assets in 2014, ending the year with about $2.2 trillion in assets under management (AUM). Wintergreen suggests the growth has been fueled by “huge advertising and PR budgets” among some of the largest and well-known index fund providers—and that the lion’s share of these assets are indexed to the Standard & Poor's (S&P) 500.

“All told, the three giants control more than $8 trillion of assets, much of it in passive investment strategies,” Wintergreen reports. “Students of market history know that index mania—like other market fads before it—will not end well.”

David Winters, CEO of Wintergreen Advisers, adds that trillions of ordinary investors’ dollars are now committed to “a mechanistic strategy that, day in and day out, simply buys stocks without a thought for their actual underlying value.” As the research explains, since the S&P 500 is market-capitalization weighted, “it suffers from the flaw of being driven by momentum.” This means rising markets cause more money to flow into the biggest companies, which drives their prices higher, which triggers more buying by passive index funds, on and on until the bear arrives.

Of course investors want to see market growth and growth within their indexed portfolios, Winters says, but the analysis suggests this pumping pattern has investors continuing to pour dollars into index funds “in the gravely mistaken belief they’re enjoying a virtually free lunch.”

“The sad reality is that index funds have turned ordinary investors into the pawns in a game that undermines the integrity of American markets and imposes costs on society that don’t show up in index fund expense ratios,” the report claims. “We believe that one consequence of this is that billions of dollars of value created by American companies are being diverted to a select few executives [of S&P 500 companies], while ordinary investors, distracted by ‘low fee’ hype, are subjected to dangerous risk concentrations in their retirement portfolios.”

Next: What’s the problem with indexing? Concentration and governance.