While index funds have had their share of critics, they could always rely on academia to defend them. Until now.
A small but growing number of academics are arguing that index funds are “evil” and “strangling the economy.” (These quotations are from the headline of a September article in the Atlantic magazine.)
If such attacks widen, index funds could face significantly higher costs in coming years even if they successfully fend off the legal challenges spawned by those academic naysayers.
Critics base their argument on the allegedly anti-competitive effects of index funds owning large positions in each of the companies within an industry — businesses that are supposed to compete with each other. It’s at least theoretically possible that those funds would be better off if those companies decided to collude rather than to compete.
And at least one major academic study, soon to appear in the prestigious Journal of Finance, finds empirical support for this theoretical possibility. The study focused on the airline industry, and found that airline fares are as much as 10% higher than they would be otherwise because of common ownership stakes among index funds and other large institutional investors.
Not all researchers agree with this study, needless to say. Alon Brav, an economist at Duke University, told me in an interview that the “empirical evidence is far from settled.” He referred me to research by economists at the University of Virginia and the Atlanta Federal Reserve which found that the correlation between index fund common ownership and higher airline prices disappears after correcting for what they believe are statistical errors.
Lawrence Tint, chairman of Quantal, a risk-management firm for institutional investors, raises a theoretical objection. Until 2000, Tint was U.S. CEO of BGI, the organization that created iShares and is now part of Blackrock, which currently maintains one of the largest family of index funds and ETFs. In an interview, Tint said index funds benchmarked to the broad market would not benefit from collusion, and thus have no incentive to encourage anti-competitive behavior. That’s because any gain from collusion in one industry would be offset by increased costs at other companies owned by those funds.
My intent in this column is not to take sides in this debate, but to focus on the potential costs to index funds. Even if the antitrust argument ultimately fails, those funds still could face significant legal fees if they have to defend themselves against numerous lawsuits. And if those lawsuits are even partially successful, index funds could face much higher fees for other reasons. Some of the proposals being put forward, for example, could require index providers such as Vanguard to break up into numerous separate legal entities.
The filing of such lawsuits appears to be just a matter of time, Edward Rock, a law professor at NYU and director of that university’s Institute for Corporate Governance & Finance, said in an interview. In fact, he added, it appears as though some of the legal scholars involved in this debate are actively encouraging such suits and regulatory punishments.
Rock was quick to add that he does not think the antitrust case against index funds has any merit. On the contrary, he said some of the arguments being made against Vanguard and other large index fund providers are “just nutty.” As a way of protecting index fund providers from the threat of endless frivolous lawsuits, he and a colleague at NYU have proposed that the funds be provided explicit legal immunity from antitrust actions so long as they own less than 15% of a company, have no board representation, and engage in no more than “normal” corporate governance matters.
Rock added that another unfortunate consequence of this debate is that index funds may choose to withdraw from any involvement in corporate governance matters. While that may be the legally safe thing to do, Rock thinks it would be a step backwards for index funds that have only recently begun to exercise their voice on topics such as executive compensation. Investors will suffer as a result.
How much could index fund fees rise because of these lawsuits and related actions? Vanguard declined to say. “As there are no current pending lawsuits on the matter, we’ll refrain from speculating on the costs associated as it remains hypothetical,” a public relations representative at Vanguard said in an email.
In the meantime, of course, index funds far and away remain the lowest-cost vehicle for gaining equity exposure. For example, the annual expense ratio for the Vanguard S&P 500 index fund VFINX, +0.83% , the original index fund and one of the largest currently, is just 0.04% when investing $10,000 or more. That compares to an average ratio of 0.82% among actively managed funds, according to the Investment Company Institute, the mutual fund industry’s trade association. So it would take a big increase in fees for index funds to stop being the overwhelmingly low-cost alternative.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com .