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dan bortolotti

With all the malfeasance in the world of finance, you wouldn't expect the humble index fund to be near the top of the Most Wanted list. This is, after all, an industry where people make millions through insider trading, and where sleazy advisers buy penny stocks for senior citizens. Yet, who is the target of the fiercest outrage in the financial industry these days? Those unspeakably malignant index funds and ETFs.

These are the same funds that allow even the smallest investors to build diversified, tax-efficient portfolios at rock-bottom cost. They've liberated investors from the corrosive costs of traditional funds and made it possible to invest on your own without having to research companies and buy individual stocks. So what's with the article in the September issue of The Atlantic called Are Index Funds Evil?, with the subtitle, "A growing chorus of experts argue that they're strangling the economy – and must be stopped"?

The article's main argument goes like this. For decades, index funds have been held up as a triumph for ordinary investors at the expense of overpaid active fund managers. But their success has led to some collateral damage: namely, consumers may be paying more for some goods and services.

That's because a small number of huge index fund and ETF providers hold massive stakes in U.S. companies. Three firms – Vanguard, BlackRock and State Street – together own about 15 per cent of the shares of major U.S. airlines. Some economists argue that this high level of common ownership creates disincentives for companies to compete with one another, resulting in, for example, higher costs for airline tickets.

To use a hypothetical Canadian example, think about our five largest banks. Countless Canadian equity mutual funds own shares of several banks, and broad-market index funds own all of them. If you've ever wondered why all the banks offer paltry interest rates on savings, moribund investment products and indifferent customer service, maybe one reason is this high level of common ownership. As the manager of a huge investment fund that owns all of the banks, for example, will you hold management's feet to the fire and demand they be more competitive? Or are you better off when all the banks keep their fees – and their profits – high, even if that's bad for consumers and the economy as a whole? (I should stress that no one has published Canadian research on common ownership, and our fund industry is probably much too small for this to be a problem.)

This idea has floated among economists for decades, but no one has made a convincing link between common ownership and higher prices for consumer goods. But my beef with the Atlantic article – and the seemingly endless parade of similar ones – is how they target index funds as the villains. After all, just about all diversified mutual funds have significant holdings in companies in the same industry.

Indeed, I went back to the original academic paper cited in the Atlantic piece, and it doesn't single out index funds at all: It targets large institutional investors in general. In fact, it specifically mentions examples of active fund managers lobbying both airlines and pharma companies to keep prices higher because they owned several companies in those sectors. The authors also note that Berkshire Hathaway – Warren Buffett's conglomerate – owns significant stakes in several U.S. airlines and financial-services firms. So why is the Atlantic framing this as a story about passively managed funds?

If all of this were just the domain of ivory-tower economists, it might be harmless enough. But the research has led to calls for legal and policy changes aimed squarely at index funds. These include proposals that index funds be allowed to own only one company in a given industry and/or capping the proportion of shares they can own. Others have proposed that index fund managers be barred from voting at shareholder meetings.

Anecdotally, too, I have seen how the "index funds are evil" argument has caused new investors to second-guess their strategy. Many have recently broken free from advisers who build what I call "mutual fund meatloaf" (who knows what's really in there?), or learned the hard way that most people fail miserably at picking stocks. They've created a well-diversified, ultra-low-cost portfolio of ETFs and are on the path to becoming successful investors – and now they're being told their strategy is wrecking free markets and leading us all down a slippery slope to communism.

There's another argument we need to consider here. Common ownership of public companies through institutional investment funds may have a downside, but it has also brought enormous benefits. The evidence that index funds are harming the economy is awfully weak, but even if it were true that in some specific, unusual cases, they have led to slightly higher prices for some goods and services, this would not offset the benefits these funds bring to ordinary consumers.

In the past decade or so, the average investor has been given an unprecedented opportunity to build low-cost, broadly diversified portfolios that simply didn't exist before. Let's remember that it wasn't so long ago that building a portfolio meant picking individual stocks or paying a broker to do it for you, and people of modest means had no way of doing this effectively. Mutual funds made diversification possible for anyone with as little as a few hundred dollars, and index funds have driven the cost of investing lower than it has ever been. If saving 90 per cent on investing costs over a lifetime means paying a little more for an airline ticket once or twice a year, that's a good trade-off.

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