Have Index Funds Grown Too Powerful?

In the world of investing, it is possible to beat the market -- but it takes a fair amount of work, skill and patience. For those who lack any (or all) of the necessary ingredients, the simple, popular solution has become to invest in index funds instead. You won't beat the market, but you can count on pretty well matching it -- which isn't such a bad deal for the individual investor. However, as John Bogle, the inventor of the index fund, recently noted, with so many people putting so much capital into the hands of index fund operators, and half of that into the hands of the three largest, there is a risk to corporate governance. Who's driving this train?

In this segment of the MarketFoolery podcast, host Chris Hill and MFAM Funds' Bill Barker, discuss their perspectives on the situation.

A full transcript follows the video.

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This video was recorded on Dec. 5, 2018.

Chris Hill: Question from Tom George. "Is the size of index funds becoming dangerous?" He included a link to a commentary from the father of index funds himself, John Bogle.

Bill Barker: Bogle's article talks about not so much the returns to investors or any volatility, which is what index funds are sometimes spotted up as perhaps having a problem, given the concentration of certain stocks in index funds, but really on the voting power of shareholders and corporate governance. The trend is that there may soon be 50% of the market in index funds. Index funds themselves are highly concentrated in the three largest players -- that being Vanguard, State Street, and BlackRock. Then who's going to be exercising actual voting control over boards? That's what his article's about.

Hill: I understand the point that's being made, but I have to be honest -- it takes something pretty extreme for me to say, "Well, I'm just going to ditch the index fund that I have with Vanguard as a result of that." I mean, just the vehicle itself, the low-cost option, in terms of corporate governance, I'm not thinking about my index fund investment in that regard. I will think of my own individual stock investments in that regard. If they're becoming dangerous, they're not becoming dangerous enough for me as an investor to say I want out.

Barker: No, and I don't think that the argument is that the index funds themselves will end up with lesser returns because of this, but more that the governance, and who is exercising voting control over the decisions of companies, where is that going? To his credit, John Bogle is not saying, "Oh, don't worry about it. Vanguard has 51% of the index market, and they're good people, so we never need to worry about them doing the right thing." His outlook is, "This is a potential structural problem, and one that people should be aware of."

There's no such thing as a free lunch. As great as index funds have been for investors, and the article itself points out, with approval, the description of, the 500 Index Fund is the most consequential or the best thing that's happened to investors. He's definitely positive on what has been achieved. In fact, the ability of investors to today, get for either virtually nothing or actually nothing in the case of Fidelity's new index fund products, a wide diversification for their investments at any moment, any time, comes with a cost. That is, as they become more and more and more attractive, the voting rights aggregate into fewer and fewer hands.

Bill Barker has no position in any of the stocks mentioned. Chris Hill has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.