The Power of Passive Managers

The top three money managers in the U.S.—BlackRock, Vanguard and State Street—are responsible for a combined $11.5 trillion in investments.¹ These “Big Three” are the largest shareholder in 88 percent of the companies comprising the Standard & Poor’s 500 Index.²  Here we will discuss the power of passive managers.

As passively managed assets grab a growing market share, this concentration is likely to increase since these money managers are the leading index fund providers. Together they manage about 90 percent of all passively-managed equity fund assets.³  That begs an important question.  Does this concentration of equity ownership represent a new financial risk?

The New Face of Financial Risk?

The Big Three’s large shareholdings give these asset managers a unique and powerful influence in corporate America through voting, personal engagement with company management and the potential that company executives could adopt the agenda of these asset managers. Of course, the one power they do not have is the threat to sell shares since they are required to maintain ownership in an index’s constituent companies.

Historically, investors in passively-managed strategies had little interest in being activist owners since their sole objective was to match the performance of the index they sought to replicate. That’s changing however.

Passive asset managers have declared that they want to become more active owners. For instance, while State Street has discussed how they have centralized their governance and stewardship process in order to maximize their influence with businesses.

This growing concentration in equity ownership may have several potential consequences, including:

• Anticompetitive Effect—Concentrated ownership can reduce the competitive forces in the marketplace. For example, a passive manager may not support aggressive price cuts, which could reduce revenues for industry competitors also owned by the manager. One study showed that common ownership in the airline industry has contributed to ticket price increases ranging from 3 to 11 percent.⁴
• Inefficient Pricing and Capital Allocation—Security valuation and the allocation of capital have traditionally been based on a thoughtful, albeit imperfect, process that weighs potential returns and risk. Investing in companies simply because they exist in an index, irrespective of fundamentals, may upend efficient markets to the harm of long-term economic growth.
• Increase Herding Effect and Market Volatility—Investor anxiety could be amplified as investors exit from popular indices en masse, resulting in a disproportionate effect on a narrow list of securities.
• Exacerbate Social and Political Divisions—As passive managers become more active owners on issues with social and political impact (e.g., gun control), it may subject businesses to the backlash of interest groups in opposition to whatever corporate governance policy objective they may pursue.

Sources:

1. https://www.institutionalinvestor.com/article/b15130vb18nnl1/2017-americas-top-300-money-managers
2. https://www.cambridge.org/core/journals/business-and-politics/article/hidden-power-of-the-big-three-passive-index-funds-reconcentration-of-corporate-ownership-and-new-financial-risk/30AD689509AAD62F5B677E916C28C4B6/core-reader
3. https://www.cambridge.org/core/journals/business-and-politics/article/hidden-power-of-the-big-three-passive-index-funds-reconcentration-of-corporate-ownership-and-new-financial-risk/30AD689509AAD62F5B677E916C28C4B6/core-reader
4. https://www.cambridge.org/core/journals/business-and-politics/article/hidden-power-of-the-big-three-passive-index-funds-reconcentration-of-corporate-ownership-and-new-financial-risk/30AD689509AAD62F5B677E916C28C4B6/core-reader