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Passive Investors Don't Need No Stinkin' Votes

Mar. 11, 2018 8:05 AM ET20 Comments
Cullen Roche profile picture
Cullen Roche

People are still losing their minds over "passive investing". Here's the CEO of a high fee fund management company complaining:

"Passive investors don't engage the market with finely tuned attention to each company. They don't help allocate capital specifically to well-run companies with competitive advantages and long-term growth prospects. Nor do they invest in discovering price disconnects between securities, undervalued assets, or future innovators."

Oh man. Lots to unpack there. Let's go one sentence at a time because this is a big ol' hot mess of words:

"Passive investors don't engage the market with finely tuned attention to each company. "

We should get this out of the way upfront - there's no such thing as pure passive. I won't get into this for the billionth time here so go read this long diatribe about it if you care to. That said, let's use his term "passive" to be consistent.

Passive investors (what are actually low fee low activity indexers) do not believe in stock picking so of course they don't engage in paying attention to each company.

"They don't help allocate capital specifically to well-run companies with competitive advantages and long-term growth prospects."

This is simply untrue. The S&P 500, for instance, is an index with specific rules constructed by Standard & Poor's. When a company fails to meet those standards, the index drops the company and all the ETFs or other index funds that mimic the S&P 500 will do the same. An index fund tries to track the performance of its underlying companies. For instance, when Enron blows up there will always be more active investors taking the other side of index fund buying that will push the price of Enron to $0. The fact that Enron is in the index is irrelevant to Enron's business success. If the company fails, there will be active investors who arbitrage the other side

This article was written by

Cullen Roche profile picture
Mr. Roche is the founder of Discipline Funds, a provider of multi-asset low cost ETFs and financial advisory services. To learn more about Discipline Funds please see:https://disciplinefunds.com/

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Comments (20)

DivEngineer profile picture
Getting votes for everyone that owns shares via an ETF is probably difficult and costly especially for a small company. My issue is with your statement of having only a small effect. That is why I do not like institutions voting. They drown out the individuals vote and make it almost wasted. I don't know how to do it without adversely affecting small companies but there needs to be a way to make the individual votes count because institutions are basically a rubber stamp when it comes to voting in my opinion.
Retired Investor profile picture
Large Institutions are the ones that got energy companies to report their climate change risks. I don’t see how any individual could generate enough votes to have done that considering the employees and Board members of any company own a large percent of the stock held by individuals.
DivEngineer profile picture
If true, that is the only thing i have ever seen or heard of them accomplishing. The vast majority of the time they are a rubber stamp for outrageous and undeserved salaries and yes votes for good ole boys of the CEO.
XXthCentMan profile picture
Maintaining the integrity of the electorate in corporate operations is a notable cost. For large corporations it can easily get buried in overhead but for smaller entities the cost becomes significant & can easily cause a reduction in the net returns available for share owners. In particular there are certain securities that suffer very heavy drag from this cost. I'm thinking of closed end fund common shares but they are by no means the only ones to get impacted. In fact voting in corporate elections though has perhaps even less effect then casting ballots in general government elections.
DivEngineer profile picture
I personally feel voting should work just the opposite. I don't think institutions should be allowed to vote. Either let the fund stock holders vote based on their ownership or no vote at all. I do not feel institutions have my best interest in mind. Let individual stock owners be the only ones allowed to vote.
kimboslice profile picture
The stock market is an auction. So, a fund manager who "beats the index" is trying to determine which stock will gain popularity in the auction *after he buys it* .This requires 1. the fund manager has discovered the company's higher value before the others have or 2. the company had an unpredictable success and the fund manager predicted it before the others did. 3. the fund manager is able to see facts that others cannot understand.

Strangely enough, a few rare managers seem to have this ability.

Yet, for an investor to beat the index by a significant amount, you must have a large proportion of your investment in the mutual fund run by this great manager or managers. Otherwise you may just be like an index, which is how I ended up.

Starting out investing, I bought several different funds and now I have a bunch of them. I feed more money to the better ones but I think my funds all put together are likely close to the W5000 index. Later, I have inherited some mutual funds, further making my portfolio a potpourri of funds.

What's nice about and index fund is 1. super low cost 2. tax efficiency 3. is always "average" which is untrue of many managed funds.

The expense ratio for Vanguard Total Stock Market index fund admiral shares is 0.05%
Jerbear profile picture
The CEO is a dinosaur who just realized his is in the tar pits on his way to becoming a fossil.
How about a discussion of how mutual fund companies (passive and active) have done a lousy job voting for the best interest of shareholders. One example, why do fund companies like Vanguard allow CEO’s and board members to act and be paid like Kings and Queens (Royalty). It seems to me nobody should be allowed to appoint themselves billions of dollars in earnings (for one person) at a public company unless it is a founder who chooses to share her company and go public (cash out or in). Don’t mutual fund companies have a fiduciary duty to protect share holders (the little guy)? They claim they do. They have the voting power to stop it. Vanguard itself does not pay executives ridiculous salaries or frivolously spend corporate money (they are not public) yet they allow (or do not try to stop) any public official from doing so....I have never even heard about a fund company even questioning anything.
WhitecollarThugs profile picture
You are right. Ultimately the fund management companies are like the elected government officials -- they both answer to the corporate entities that fund them. The voting minions are a mere inconvenience that must be tolerated, pacified, and worked around.
j. hughes profile picture
Mr. Roche,
Remind me not to piss you off, especially when you are right.
RJKRJK profile picture
If I understand this correctly, by saying " more active investors won't take the other side of these trades" is this hedge fund trader complaining that there aren't enough dupes to supply him with their money while at the same time being either completely ignorant or disingenuous about what "passive" investing really is?
Economic Analyst profile picture
I believe every amateur stock picker should go to a practice trading account and see if they can beat the S&P 500 before they advise others to go in the deep end of the pool without a lifejacket.

Varan profile picture
Hilarious. We should be thankful that the good CEO did not add that it is immoral for investors not to pay high fees to acquire the privilege of investing in the funds of his company.
Wissahickon Capital profile picture
We are in agreement on 80%+ of the active-passive argument, but I think you misstate the last point, a valid one in my opinion...

"They should not get a vote on corporate governance as they don't do the work to develop wise judgments about how to vote."

Not sure I agree passive investors shouldn't get a vote, as you note the definition of "passive" itself is more of a spectrum, but the man is referring to the threat of passive investing to corporate governance, not stock picking (even if he is potentially doing so for the wrong reasons).

Investors have been becoming more passive for years. People used to just own shares in businesses, usually knowing management personally. Then, they hired stock pickers to buy them shares. Eventually, people were hiring an advisor to hire stock pickers to buy them shares. Now in 401k's, people don't even get to hire the advisor directly. Long story short, few people know what they own nowadays and get overcharged by middlemen for the privilege. Jack Bogle is a hero in the sense he cut the fees out -- if you are going to get the market return less fees / tax inefficiency, then cut out the fees / turnover. However, people now have even less of an idea what they own and internal management teams take notice.

Not sure what the solution is, probably a new market equilibrium with much lower active fees but still a good % of active management as a whole. Additionally, it would be helpful if the active management were actually "active" (i.e. substantial avg position sizes rather than closet indexing). I still recommend index funds / dollar cost averaging to virtually everyone I know, but deep down I know there are limits to this "free riding" before overall market return suffers. We will be replacing visible "active management" fees with less visible "insider management fees", anyone who's worked for a publicly traded company knows this.

(Interesting corollary, I think there's never been a better time to actively invest in good/aligned management teams as they become rarer and rarer.)
I like ETF's, its true I don't research every name in the fund. That doesn't mean I cant though. I'd rather research and try to time a particular stock trade. Thanks for speaking out against that bully lol.
ETF's are the way to go, try SCHB,SCHG, lowest cost, no advisor needed!
There is only one honest way, honest way, to make money in the "Stock market"--dividends. All else is a zero sum gamble, for someone, somewhere.
I tend to agree- dividends and companies that grow them have been my small portfolio since I had my first chance to build my own IRA.

That said, "buy and hold" works better with dividend re-investment than counting on stock price growth (AT&T for one example).

But I suspect some in the financial planning industry are being hurt by their inability to show any appreciable advantage over index funds.

People like me who were warned early in their investment lives to avoid frequent trading and advise from those who benefit from giving that advise are not good customers.
Hardog profile picture
Roger that I totally concur.
Indexes are also a way to invest in overseas markets when the individual stocks aren't sold on the American markets. No reason why one can't use Index, CEF and individual stocks.

There are various degrees in which they are used.
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