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America’s Most Popular Investment May Be Toxic

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The virtue of index funds is well known. They tend to offer higher investment returns than actively managed mutual funds, in part because of their lower fees. That’s made them one of the most popular investments in America. Nearly $145 billion flowed into these funds in the first 11 months of the year, according to Investment Company Institute. At the same time, $161 billion flowed out of actively managed mutual funds. But perhaps we have gotten too much of a good thing.

That’s the conclusion of a number of recent research studies that came out this year. Their findings: The growth in the amount of money in index funds is chipping away at the true spirit of stock ownership. The issue has to do with the fact that index funds are so-called passive investors, meaning the funds and their managers don’t pick the companies they invest in. They are selected by an the company that creates the index, like Standard & Poor’s. And the investors have to go along for the ride.

That’s been good for investment returns. Many studies have proven, that investors, even professionals, tend to buy and sell at the wrong time. According to Morningstar’s most recent Active/Passive Barometer report, actively managed funds have generally underperformed their passive counterparts. More than three-quarters of active managers in the U.S. Large Cap category lagged the equal-weighted composite of their passive peers during the ten years ending December 31, 2014.

But what may be good for investors individually, may not be good for the economy or the market as a whole. As passive owners snag a larger and larger share of the companies in the market, they change how companies are managed, so the new studies say. First of all, their growing presence during proxy season wields power, when companies put up proposals to shareholder votes. And although they aren’t actively run, index funds still vote shares. The problem is index funds are more likely to vote as a group, according to a paper from Peter Iliev and Michelle Lowry at Penn State University. Traditional actively managed funds are “less likely to vote in a ‘one size fits all’ manner,” according to the paper. So more index funds means fewer disparate groups are keeping on top of management.

Second, while they aren’t watching individual managers, index funds are more likely to vote for provisions that take power away from managements, according to a papers from Wharton School professors Ian Appel, Todd Gormley, and Donald Keim, titled “Passive Investors, Not Passive Owners.”

“Passive investors appear to exert influence through their large voting blocs—passive ownership is associated with less support for management proposals and more support for shareholder-initiated governance proposals,” the paper says.

That’s good for problem companies, but it can dilute the power of companies that actually have too good leaders. And passive funds, which don’t have the ability to chose, seem to treat all companies the same way.

Lastly, index funds tend to not just own one company in an industry, but most of their rivals as well. What happens, according to a paper Martin Schmalz, assistant professor of finance at University of Michigan wrote with Jose Azar and Isabel Tecu of Charles River Associates, is that stock ownership becomes too concentrated when companies like Blackrock or Vanguard, two large managers of index funds, vote the shares of passive funds. It can create anti-competitive behavior in an industry.

For example, U.S. airline tickets prices are 11% higher because the largest index funds that track the S&P 500 own not just American Airlines (AAL), but Delta (DAL) and United Continental (UAL) as well. And common ownership makes companies less likely to want to compete with rivals. If that sounds like hocus pocus, Schmalz likens it to two gasoline companies on opposing corners. If they have different owners, they might undercut each other’s prices. However, “if you own both gas stations on both sides of the street, are you still going to do the same thing? Probably not.”

Schmalz worries that a lack of competition is driving up prices for consumers and making the economy less dynamic. But other research suggests that the structure of index funds is a trouble for the stock market as well.

The reason John Osterweis, founder and chief investment officer of Osterweis Capital Management, says is because index funds are capitalization weighted. This dynamic often favors the largest companies, which make up the largest weights in the most popular index, and it has a momentum effect. And as those companies’ market value gets bigger, a greater percentage of the money index funds invest flow to those companies. Osterweis points to the returns in the first part of this year as an example. In the S&P 500, the top 10 contributors were up an average of 35%, while the bottom 490 stocks in the index were down almost 7%, he says.

The result, Osterweis says, is that investors through index funds get trapped in a few companies, and it’s the same companies everyone else is buying, so they tend to be over priced. “You might underperform for a period of time, but ultimately you might outperform because you might not be trapped in this thing,” says Osterweis. The question is whether index funds have become such a force that they have the economy trapped as well.