In a recent letter to his hedge fund shareholders, Pershing Square founder Bill Ackman examines the influence of index funds on corporate America. As a result of the increase in assets under management in index funds, Ackman notes that Vanguard, Blackrock, and State Street “often cumulatively own 12%, and as much as 20%, of nearly every public company.” Ackman worries that with increased levels of ownership, index funds will “effectively control Corporate America and the corporations of many foreign countries,” leading to negative effects for the corporations and economy as a whole “absent the counterbalancing force of large active investors and improvements in the governance oversight implemented by passive index fund managers.” According to Ackman, the effect is compounded by the large number of actively managed funds that are “closet indexed.”
Ackman is concerned about the effect of the increased voting power of index funds. Though he acknowledges that index funds tend to be long-term holders, Ackman argues that they “are not compensated for investment performance, but rather for growing assets under management.” They also face the challenge of understanding and properly voting an overwhelming number of proxy statements in the face of restrictive budgets brought on by fee compression in the index fund space. Ackman identifies potential conflicts of interest resulting from corporate pension funds’ investments in index funds where “[i]t does not help index fund managers win business from Corporate America if they have a reputation for being an activist or if they support activists.” As a result, Ackman encourages investors to not solely consider fees in selecting an index fund, but also to look at a fund’s approach to governance.
Additionally, he is concerned that index fund inflows are driving an increase in valuations in index constituent companies. While stopping short of calling the phenomenon a “bubble,” he suggests that “it shares similar characteristics with other market bubbles.” Ackman explains that “large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return.” However, when index funds eventually experience outflows, constituent company valuations will no longer be artificially propped up, leading to decreased index fund returns and a cycle of ever-more outflows.
Clouding Ackman’s argument is Pershing Square’s -19.3% gross return for 2015, leading some to suggest that his issue with index funds is merely an attempt to distract investors from his own performance issues. Chuck Jaffe examined Ackman’s claims in a recent column and cited figures that “the total impact of index additions and deletions has been estimated to be less than 0.3% a year. In short, not too big a deal.” On the governance front, Jaffe noted studies show that “index funds actually reduce the need for corporate activism by encouraging more shareholder-friendly practices.” Index funds, he argued, can best represent shareholders by voting in alignment with long-term interests, rendering them “the kind of activists who work against quick-play artists like Ackman.”