Passive Investors Don't Need No Stinkin' Votes

by: 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 of the index fund's buying and they will earn a profit driving Enron to $0.

The key point here is that less active index fund buyers require more active index fund sellers to make the market in the underlying positions. To argue that more active investors won't take the other side of these trades is to misunderstand the two-sided nature of every market transaction.

Now, here's the most interesting part of the article:

"Rather than careful guides for growing companies, passive investors are largely freeloaders. These firms merely ride share values that change based on capital-allocation decisions made by the active investors who are the actual stewards of capital. They should not get a vote on corporate governance as they don't do the work to develop wise judgments about how to vote."

Good point, my man! I wouldn't call them "freeloaders". Remember, the less active investors incur real costs to have more active investors make a market for them. For instance, when Enron is going to $0 those indexers aren't "freeloading". They're incurring a real cost that more active investors are taking the other side of the trade on. It might not look like a cost because the rest of the index performs okay relative to Enron. But any index without Enron in it is outperforming the index with Enron, and those investors in the index fund with Enron are incurring a real relative cost.

But the last point is more interesting. These less active indexers don't believe that more active investors can actually make "wise judgments" about individual companies. That is why they're indexing! The data on this point is uncontroversial. More active investors are very bad at picking which stocks beat the index. So the idea of not voting to influence the corporation is perfectly consistent with the way these less active investors think. Should we ban these less active investors from voting? No. I doubt you have to because I suspect the vast majority of them don't even want to vote.

So I guess maybe we can stop losing our minds about "passive investing" now that we got all that cleared up!¹

¹ - I look forward to the next hyperventilating article about passive indexing written by a high fee active mutual fund firm that is trying to fend off extinction.