The Effect of Index Funds and Index ETFs on the MarketSubmitted by CHARLES CARROLL FINANCIAL PARTNERS on June 3rd, 2017
The Effect of Index Funds and Index ETFs
A recent report issued by ICI, (The Investment Company Institute) stated that mutual fund management fees continue to go down for investors. We believe that this is mainly due to the influence of Index Mutual Funds and Index Exchange Traded Funds as current investments of choice. As you may already know, these types of funds have the lowest management fees in the industry. So it stands to reason that if more money went to the lowest cost mutual and exchange traded funds, that overall cost of investing in mutual funds and exchange traded funds would go down as well. Couple this with a surge in the popularity of these types of investments and its no wonder that mutual fund expenses are going down. But is there another catalyst or factor effecting this move?
That factor, we believe, is that these investment products have become increasingly popular based upon two items one of which is the continuing debate of active versus passive investing. However, while passive investing has shown significant returns over active lately, the debate as to passive investment's popularity should not just be a discussion about active versus passive. We believe it goes much deeper. There is powerful and clearly market influencing ancillary move by 401K providers to move away from higher cost actively managed funds into Index Funds and Index ETFs.
The Department of Labor (DOL) may be the instigator of an unwelcome asset allocation and potential threat to the general market place. The Fiduciary rules implemented by and dictated by the DOL preach the importance of fair dealing and the avoidance of conflicts of interest created by advisors placing client assets into higher cost funds. We are seeing that the result of this action has unduly influenced 401K administrators and their Trustees to move away from actively managed funds providing diversification and into Index funds with their fixed allocation models to avoid negative scrutiny by government authorities due to the new DOL rules.
Why is this important? In 2016, most financial service companies providing actively managed mutual funds and exchange traded fund products to the public lost investment dollars to two fund companies, Vanguard and Dimensional Funds. Vanguard is primarily known for its Index funds (a passive investment philosophy), while Dimensional Funds is known for actively managing the holdings in their funds. In 2016, Vanguard took in $233.7 Billion in NET new money while actively managed funds saw their assets shrink by more than $295 Billion.
The Vanguard success in our opinion is very troubling. Not because of its passive stance, but because of its implications.
Most index funds as stated above are weighted based upon the market capitalization of the stocks in the index. This means that the larger the market capitalization of a stock, the more money goes into that stock. (Market Capitalization = stock price x # of shares available). Therefore, the largest companies get the most investment dollars from Index Funds and Exchange Traded Funds
Let’s look at the top five holdings in the Vanguard Total Stock Market Index and Vanguard S & P 500 Index shown above.
Top 5 holdings of:
Vanguard Total Stock Market Index Vanguard S & P 500 Index
1. Apple 2.85% 3.66%
2. GOOG & GOOGL 2.17% 2.64%
3. Microsoft 2.00% 2.57%
4. Amazon 1.49% 1.78%
5. Facebook 1.41% 1.72%
The table above tells us that out of every $1.00 invested into the Vanguard Total Stock Market Index fund or the Vanguard S & P 500 Index fund, on average $0.03 goes to Apple. This doesn’t seem like a big deal. However, when you take into consideration that nearly $40 Billion flowed into the Vanguard Total Stock Market Index, and $25 Billion flowed into the Vanguard S & P 500 index, in 2016, it means that nearly $2 Billion was invested into Apple from just these two funds. When you compound that investment by the number of total market and S & P 500 funds in the universe of equity funds and ETFs and it means that Apple has an enormous push behind its stock price not because of a change in its earnings or operations, but because of a change in investor philosophy and new governmental regulation.
This is troublesome. Momentum from governmental edict and investor predilection, not from innovation or disruption of past financial practice, is influencing stock price. What is the outcome? Investors all own the same things, and are heavily weighted into the largest capitalized stocks especially when it comes to the largest base of assets available to the market, retirement funds.
Please understand that we are quite aware that most of these stocks are currently in your portfolios. However, your ownership of these stocks is not contingent upon a market capitalization philosophy and that ownership will change if the earnings of any of the above firms fall from the expectations that we have set.
When the investment cash flows start to dry up or when earnings turn negative, passively managed index products will still have their shareholders invested in these stocks. The last person out should then turn off the lights. However, in passive investments, no one will be there to flip the switch.