The concentration of economic power has led to spectacular investment returns.
As contrarians, we always ask when will it end and how will it end?
The following article was originally published in “What I Learned This Week” on January 23, 2020. To learn more about 13D’s investment research, please visit our website.
One link that has not received as much attention as it should is the relationship between consolidation and passive investing. The winner-take-all cycle has turned for two decades: Digital natives and sector leaders leverage expertise and spending power to maximize digital efficiencies. They suck in profits from smaller, less nimble old-economy companies. The stocks of the digital natives and sector leaders soar, accounting for the vast majority of growth in the indexes they populate. Inflows to those indexes spike. Active managers have no choice but to capitulate — if they don’t own the digital natives and sector leaders, they will underperform to the point of extinction. More money flows to the already-dominant firms. The indexes become virtually unbeatable. There’s no hidden success stories left to discover. Outflows from active managers continue to accelerate.
As of last August, assets in index-tracking equity funds eclipsed assets run by stock-pickers — $4.27 trillion versus $4.25 trillion. Globally, assets managed by index funds now exceed $10 trillion. If the internal index-tracking strategies of sovereign wealth funds, endowments, and pension plans are included in that calculation, the total swells to approximately $20 trillion.
It is no coincidence that the meteoric rise of passive investing has coincided with one of the most intense periods of industry consolidation in American history. Roughly 75% of U.S. industries are more concentrated today than they were in the mid-1990s. The top-decile of companies now account for nearly all economic profit — i.e., how much companies earn above the cost of capital (chart below). Study after study has come to dire conclusions about the consequences of this corporate inequality, from wage stagnation to suppressed capital spending, depressed new business formation, and slowing innovation.
Index investing has no doubt thrived because it’s effective — delivering better returns for lower fees, on average. Its continued rise appears unstoppable. At least for now. As Harvard Law professor Einer Elhauge told Bloomberg recently: “Index funds ‘are great for investors…but part of the reason they’re great for investors is exactly because of the anti-competitive effects.’”
As we’ve tracked for years in these pages, a backlash against consolidation is coming. The pendulum will swing from wealth accumulation to wealth distribution. Throughout history, it always has when the concentration of economic power reaches an extreme. So far, dysfunction in Washington has stopped action even when it has bipartisan support. But the political chorus remains loud and clear: a reinvigoration of antitrust is required to curb the monopolistic power of tech giants and sector leaders.
Now, from the FTC to the Justice Department, attention is beginning to be paid to indexing. And it’s not just about the immense power of the Big Three indexers — BlackRock, Vanguard, and State Street. The fact is, for passive to be systemically healthy, active management must remain vigorous and influential. The market needs price discovery to elevate deserving winners and control euphoria. And companies need active shareholders to encourage competition and provide accountability for greed and indiscretion.
At what point has passive grown so dominant, the market becomes dangerously extreme and only offers opportunity to already-entrenched corporate superpowers?
Indexing, by its very nature, is biased towards bigness. Retail investors are drawn to mega-cap indexes because they contain brand names they know, trust, and can track just by following the news cycle. Three of the top four ETFs in terms of AUM track the S&P 500. In addition, the more diverse a company’s business and track record, the more it can fit into almost any index construction. In WILTW June 15, 2017, we quoted Horizon Kinetics’ Steven Bregman on this topic:
Aside from being 25% of the iShares U.S. Energy ETF, 22% of the Vanguard Energy ETF, and so forth, Exxon is simultaneously a Dividend Growth stock and a Deep Value stock. It is in the USA Quality Factor ETF and in the Weak Dollar U.S. Equity ETF. Get this: It’s both a Momentum Tilt stock and a Low Volatility stock. It sounds like a vaudeville act.
The market today clearly reflects this bias. According to CNBC, the 10 largest stocks in the S&P 500 and the Russell 1000 benchmarks now account for 23% and 21% of the total index market cap, respectively — the highest levels since the 1990s tech bubble. A wide spread has formed between the valuation of the most expensive 20% of stocks and the cheapest 20% (chart below). It’s likely only to get worse. Roughly 25 cents of every dollar that goes into State Street’s SPDR or the Vanguard 500 Index Fund, goes into technology stocks — mainly FAANG+ — up from 15 cents a decade ago.
Accountability is a primary concern. The passive movement is founded on the idea that you shouldn’t sell out of an index almost no matter what the market says. GE may be bleeding cash as it stumbles under the weight of disruptive competition, but you hold GE because GE is part of the S&P 500 and all the other index members will more than cover GE’s weakness.
While U.S. equity indexes break one record after another, the percentage of listed companies in the U.S. losing money over 12 months sits close to 40%. Outside of post-recession periods, that’s the highest level since the late 1990s. And of the 100 biggest money-losing companies, roughly 75% saw their shares rise in value over the same 12 months. Small companies did not enjoy that leniency from investors: only 41% of all the loss-making companies saw their shares rise.
This dynamic does not only apply to poor financial performance. How much financial consequence were the likes of Facebook, Boeing, and Wells Fargo spared following their respective scandals because passive rendered capital unreactive?
Despite their voting power, passive giants do not bring proportional accountability to boardrooms. The Big Three indexers now own roughly 22% of S&P 500 shares (chart below). Yet, according to Morningstar calculations, Vanguard employs just 21 people to do the work of corporate oversight at a cost of $6.3 million a year, a pittance compared to the more than $5.6 trillion they have under management.
It is unrealistic to expect three indexing giants to oversee the vast majority of the U.S. corporate ecosystem. This is no doubt partly why Vanguard godfather Jack Bogle, before he died, warned that too much money may be in too few hands.
How and when concern about indexing turns to action remains unknown. However, passive inflows will not abate, meaning winner-take-all dynamics will continue, and in turn, excesses will only grow. It is a challenge indexers must be prepared to confront. And it is an opportunity active managers must be prepared to capitalize on.
The following article was originally published in “What I Learned This Week” on January 23, 2020. To learn more about 13D’s investment research, please visit our website.
