The Duty to Diversify and the Logic of Indexing

Abstract

Index funds, such as those that track the S&P 500, are popular with investors because they offer maximum diversification—and thus minimum risk—with management fees that are far lower than those charged by traditional, actively managed stock-picking mutual funds. As a result, investors have flocked to such funds, which have grown dramatically in size. But many observers find this trend alarming because they see index funds as a threat to both corporate governance and competition.

Most critics have focused on the passivity of index funds, which they see as a failure of fund managers to do their duty as stockholders to vote with care and otherwise to engage with portfolio companies to induce optimal performance. They also see index fund passivity as free riding on the efforts of other stockholders who do their duty to monitor investee companies. In other words, they see a case of market failure in which index funds offer higher returns at lower cost because they shirk their responsibility to participate in corporate democracy. Other critics focus on the idea that index funds own a large percentage of the market and then jump to the conclusion that they will use their market power to cajole or coerce portfolio companies to modify business strategies. In short, the critics are worried that index funds will both do too little and do too much. But it cannot be that index funds will use their power to meddle in the affairs of investee businesses and, at the same time, neglect to engage with the management thereof. This puzzling division of opinion suggests that index funds are not well understood—even by many sophisticated observers.

This Article addresses the confusion about index funds and concludes that the worries expressed by the critics are not only unfounded, but also that index funds make the market more efficient. Specifically, that critics have failed to see (1) the compelling logic that leads investors to invest in index funds, (2) the natural constraints on index fund managers that prevent abuses, and (3) the significant ways in which index funds augment the disciplinary forces of the market. This Article focuses solely on true index funds—those that track a broad-based capitalization-weighted market index (such as the S&P 500). Although there are many funds that track other indices— including industry sectors and even idiosyncratic investment theories—the argument here focuses on the logic of investing in the market as a whole (or as much of it as is reflected by the S&P 500).

First, ordinary investors in common stock—those who have no reasonable expectation of influencing company management or business policy—have no real choice but to invest in index funds, which offer the same expected return as stock-picking funds but at the least possible risk. Moreover, an index fund investor can expect a higher rate of return over the long-term than an investor who chooses a riskier fund—even though both funds offer the same average annual rate of return. Although this may sound too good to be true, it is a straightforward implication of compounding of returns. Finally, index investors ultimately drive stock prices higher because they are willing to pay more for a given stock because they assume less risk and expect higher returns by virtue of indexing. As a result, investors who decline to invest in an index fund must pay more for the stocks they buy than the prospect of expected returns justifies because they assume more risk than necessary.

It also follows that fiduciary duty requires investment advisers to recommend index funds to their ordinary-investor clients because the duty of care is measured by how a reasonably prudent person would act in the conduct of their own affairs. This is a radical proposition. It implies that much investment advice borders on fraud. It also explains why the securities industry has so vigorously opposed regulations that would classify broker-dealers as fiduciaries.

Second, the foregoing logic applies doubly to index fund managers, who are required by statute to be registered investment advisers and are thus fiduciaries. For an index fund manager, the logic of indexing leaves little room for discretion in connection with choosing or trading portfolio stocks, which must be held in proportion to market capitalization. Thus, indexing implies that research is a literal (and legal) waste because the fruits thereof it can have no use. To expend fund resources thereon or to charge the fund a fee to defray such costs is a per se breach of fiduciary duty. In contrast, the managers of a traditional stock-picking fund will almost always be protected by the business judgment rule in connection with any investment or trading decision they may make. This is true even to the extent of a decision to alter fund strategy, as long as the managers can provide some reasonable explanation for their decisions.

This same logic applies to voting and other forms of engagement with portfolio companies. Presumably, the purpose of engagement is to enhance performance and return. Consequently, managers of traditional stock-picking mutual funds have broad discretion both as to voting the shares they hold and otherwise kibbitzing with portfolio company management. But engagement is expensive. It requires delving into the operational details of individual portfolio companies. For index fund managers, whose portfolios are hedged by virtue of being fully diversified, it makes no sense to devote fund resources to such ends. One possible exception to this general rule arises when some improvement in corporate governance might make many companies better off. But ironically, such efforts have been dismissed by some critics as low-value engagement.

Third, despite their supposed passivity, index funds contribute significantly to the disciplinary forces of the market. The minimal trading they do for purposes of maintaining portfolio balance has the effect of rewarding companies who perform better and punishing companies who perform worse. Moreover, portfolio companies understand that indexing leaves no room for them to talk their way out of the consequences of mismanagement (as might be the case with the managers of a stock-picking fund). As for voting fund shares, index funds that follow the sensible practice of mirror voting—voting fund shares in proportion to the votes cast by other shares—effectively enhance the voting power of actively managed funds, which increases the voice of stockholders who have strong opinions. In other words, index funds reduce the separation of ownership from control.

The overarching point of this Article is that the logic of indexing has profound legal implications. For one, indexing should not be seen as opportunism (or market failure), but rather should be seen as an innovation that makes some investors better off without significant externalities, and without foisting any clear loss on other investors. For another, the benefits of indexing are so demonstrable that they imply that fiduciaries have no choice but to recommend that their clients who invest in common stocks invest in an index fund. In other words, it should be seen as a breach of fiduciary duty for an investment adviser not to recommend indexing to such clients, which may also explain much of the growth indexing. In short, index funds have made the financial world a much better place than it was in the past. And efforts to control their further growth and evolution should be undertaken only with an abundance of caution.

ISSN

2997-0520

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