Jack Bogle Has Discovered a Downside to Low Index Fees

Last week the inestimable Jack Bogle, the founder of The Vanguard Group and the investor who first conceived of the index fund, published an essay in which he questioned the long-term viability of the low-cost model that currently has trillions of dollars invested in such funds. His critique--and the solutions he proposes-- identifies a growing moral hazard problem in our financial markets that threatens to reduce the savings of ordinary investors unless we resolve it.

The idea of an index fund is elegantly simple, of course: rather than employ a team of analysts to intently study the markets and a gaggle of economic statistics in an effort to construct a portfolio that grows faster than the entire stock market, an index fund merely seeks to passively replicate the performance of the overall market. Since no one is doing any stock picking, no research--or researchers--are necessary, and management fees can be greatly reduced as a result.

A plethora of research has found that index funds tend to outperform nearly all actively-managed accounts in the long run, precisely because of the low management costs and the simple fact that stock picking is really, really difficult.

In the four decades since their inception, index funds have attracted an increasing share of capital, and almost one-third of all stock-market investments are currently held in passively-managed funds: investors put over $500 billion in new money into index funds in 2017 alone. The increasing popularity of index funds has resulted in an increasingly cost-competitive market, which has put further pressure to reduce management fees both in index funds as well as their actively-managed counterparts.

In fact, since the inception of the index fund their management fees have steadily fallen, to the point that earlier this year Fidelity began marketing an index fund that charges no fees at all.

However, while many see the increasing popularity of the index fund as an unalloyed gain for middle class investors, Bogle warns us that its triumph presents a potential corporate governance problem.

Index fund managers generally cannot afford to care about corporate management issues--not if they want to keep the cost of their funds down. While the Securities and Exchange Commission requires that investment management companies vote their proxies, most of them--both active and passive funds--tend to rely on the services of a proxy advisory firm for such decisions.

While outsourcing such decisions may be cost-effective, the problem is that an index fund has little reason to care about what proxy recommendations entail. Index funds compete against one another solely on management fees; since they all follow (presumably) the same stock market index, an effective nudge given from a management fund to a firm that effectively reduces its long-term profitability does not affect that index fund any differently than any other fund.

The problem is that it is not clear that the proxy advisory firms make their recommendations solely based on what’s best for the performance of the stock. There is ample evidence that these entities often pursue political agendas with their recommendations, especially when it comes to climate change or the manufacturing of weapons. Congress has debated legislation that would regulate such firms for the last year and the House of Representatives passed legislation earlier this year that would do so.  And this week the Senate Committee on Banking, Housing and Urban Affairs is taking a look at the current practices and potential changes to how proxy firms conduct their business.

Bogle doesn’t contemplate the regulating of proxy advisory firms: he would rather prohibit this outsourcing altogether and require that index funds retain a staff that handles proxies and other such decisions in-house.

While I agree that the status quo presents a potential problem not so far down the road, it is also easy to see that if the SEC were to require that index funds do such a thing that the temptation would be to expend as few resources as possible to meet this requirement. After all, the cost of shirking such a duty would fall onto the market as a whole and not one particular hedge fund.

That reality would entail some modicum of regulation to ensure that index funds--and other mutual funds as well--would take such a responsibility seriously, a requirement that I cannot fathom at present.

It is, of course, a little unsettling to read Jack Bogle recommending that investment managers spend more money on their investment activities, but Bogle’s career--which has been dedicated towards helping small investors get more from their savings--makes this advice a “Nixon goes to China” scenario, and one worth pondering.