Index fund warning must be heeded

When a pioneer points out a problem with his invention, the relevant industry should listen. The asset management world would be wise to pay attention to Jack Bogle's concerns about index funds. Mr. Bogle created the first indexed mutual fund in 1975 after he established Vanguard Group Inc. (The first Standard & Poor's 500 index fund for pension funds was established in 1973 by Wells Fargo Bank.)

Mr. Bogle, in his new book, "The Story of Vanguard and the Index Revolution," and in an article adapted from the book and published in The Wall Street Journal, warned that because of the success of index funds, it is likely that in the not far distant future a handful of money management firms will control half of all U.S. stocks.

After 42 years, equity index funds have accumulated assets totaling $4.6 trillion, or 17% of total stock market value, according to Mr. Bogle. It seems only a matter of time, he wrote, until index mutual funds own more than 50% of the stock market, and the top three index fund managers — Vanguard, BlackRock (BLK) Inc. (BLK) and State Street Global Advisors — might own 30% or more.

This, theoretically, could give a handful of index fund managers enormous power over U.S. companies through their corporate governance actions. By voting their proxies they could determine who serves on the boards of directors, how much top managers are paid and even strongly influence corporate strategies.

The U.S. has long objected to any body or group of bodies gaining too much control over the nation's companies. In the 1930s when the Social Security system was established, it was not allowed to invest the workers' contributions in stocks because of the fear the U.S. government would ultimately control corporate America through the assets of the system, bringing about a form of socialism.

As early as the 1870s the government attempted to stop companies or small groups of companies from taking control of industries and limiting competition, initially in the railroad industry, but later also in the oil and banking industries. This led to the passage of the Sherman Antitrust Act of 1890.

There is no suggestion now that index fund managers would deliberately use their potential power to control the nation's economic engines for their own advantage as did the trusts, but the potential lack of diversity in proxy voting in the companies in the index funds is troubling.

More competition in index funds would allay some of the concern expressed by Mr. Bogle, but is unlikely to develop because the established index fund managers have too great a lead, the costs of entry are high and index fund management fees have been dropping because of price competition, making index fund management an unattractive business for new entrants.

There are concerns that the huge amounts of money in capitalization-weighted index funds are contributing to market volatility in both bull and bear markets, and also that arbitrageurs front-run index fund rebalancing using computer programs to profit at the expense of other investors.

There is also the possibility of capital market distortion. Stocks in an index often have higher prices than similar stocks not in an index. This means that companies with stocks outside the index could have a higher cost of capital than similar stocks in an index.

Much indexing, perhaps most, is still done to the S&P 500, which leaves 3,000-plus stocks still outside the index funds.

Mr. Bogle did not address the market effects of the growth of indexing, but he had two suggestions of changes that might reduce concern about the growth. First, greater transparency of index fund corporate governance activities. All index funds should make full and timely disclosure of their voting policies and public documentation of each engagement with corporate management.

Second: "Enact federal legislation making it clear that directors of index funds and other large money managers have a fiduciary duty to vote solely in the interests of the funds' shareholders." Mr. Bogle believes that while that is implicit today, "making it explicit, with appropriate penalties for violations, would be a constructive step."

Of course, that does raise the question as to whether something so broad could be enforced effectively. There's also the possibility that such legislation could encourage class-action lawsuits when investors feel fund directors are not acting solely in their interests.

Still, it is time for executives in the investment management industry and academics to examine Mr. Bogle's concerns, and possible capital market distortion, and consider steps that might be taken to reduce any negative effect of the continued growth of index funds.