Hedge fund manager Bill Ackman has seen the
enemy of investors. And it’s in the form of a seemingly benign friend of
many investors – the common market-weighted index fund.
In his latest letter to shareholders of his fund house, Pershing Square Capital, Ackman starts out by discussing the reasons
for his firm’s sharp underperformance relative to their index
benchmarks last year. But he also devotes considerable space to
criticizing index funds, which have been one of the fastest-growing
segments of money management in the past decade.
Indeed, Vanguard Group,
the biggest provider of index-tracking products in the world, reported
recently that it attracted $216 billion in inflows last year, the
all-time record annual amount for any fund company.
And
billions of dollars in recent years have also flowed into non-Vanguard
index funds such as the SPDR S&P 500 exchange-traded fund (ticker:
SPY
), the iShares MSCI EAFE ETF (
EFA
) and the PowerShares QQQ Trust (
QQQ
).
Others in the alpha-chasing
crowd have criticized the inherent nature of index funds for years. But
Ackman comments are fairly lengthy and wide-ranging for a hedge fund
manager, even going as far as claiming that the indexing movement is
turning the U.S. into Japan.
“At
current rates of asset inflows, it will not be long before index funds
effectively control Corporate America and the corporations of many
foreign countries,” Ackman writes. “The Japanese system of cross
corporate ownership, the keiretsu, has been blamed for decades of
Japanese corporate underperformance and economic malaise. Large passive
ownership of Corporate America by index funds risks a similar outcome
without the counterbalancing force of large active investors and
improvements in the governance oversight implemented by passive index
fund managers.”
Ackman’s main argument –
and it’s a common knock on standard-issue market-weighted index funds –
is that a purchaser is buying inherently overvalued stocks.
“As
more and more capital flows to index funds…the valuation of the indexed
constituent companies increases,” he writes. “While some investors
consider the valuation of the index components when allocating to
specific index funds, many and perhaps most do not.”
These
are compelling arguments that deserve to be addressed. Indeed, the
creation of smart beta funds, which seek to design indexes that consider
metrics like valuation, have sprung up because of some of the valuation
concerns of standard index funds.
Ackman’s incendiary comments were worthy fodder for at least two financial writers to build columns around.
Writing on his Pragmatic Capitalism blog, Cullen Roche
writes that “even if index funds are influencing valuations then this
should create more opportunities for more active managers. After all, if
Ackman thinks that the U.S. markets are overvalued and that the tide is
essentially lifting all boats then one has to wonder why he has any
exposure to U.S. markets in the first place. The purpose of a more
active strategy is to find slices of the market that won’t expose
investors to systemic risk. This is what the higher fees are supposed to
justify. If the more active investor can’t expose those uncorrelated
corners of the market, then one has to wonder what purpose the manager
is serving in the first place.”
Roche also takes on Ackman’s assertion that
the growth in indexing will lead to more passive shareholders who
couldn’t care less about making sure that managers of companies realize
shareholder value.
“The reason indexing
has become so prominent is because there is tremendous evidence proving
that “the market” allocates capital better than more active high fee
managers,” Roche adds. “The rise of indexing is consistent with the view
that ‘the market’ does not believe people like Bill Ackman know more
about a corporation than the people who run that corporation.”
In his concluding paragraph, Roche lowers the boom on Ackman and the hedge fund industry in general.
“Indexing
isn’t eating hedge fund returns… it’s high fees that are eating hedge
fund returns. In fact, if you look at Ackman’s own shareholder letter
you’ll notice that one of the biggest things eating returns are the high
fees. The gross return of 37.3% over the last three years was cut
nearly in half due to fees which reduce it to just 22.2%! Ackman and
other hedge funds would do better by their shareholders if they reduced
their fees rather than blaming low fee index funds for their inability
to identify pockets of the market that will generate better returns.”
Matt Levine, a highly regarded financial columnist with Bloomberg View,
also weighs in with his own take on Ackman’s anti-index comments. And
his column is more nuanced and less critical than Roche’s.
Regarding the corporate governance failings
of indexing, he writes, for example, that with index investing, the cost
of investing is tumbling toward zero, and “zero doesn’t pay for a lot
of proxy fights.”
“A fund that owns a
little bit of every stock, and charges as little as possible for its
work, can’t justify the same level of active monitoring as a fund with a
few concentrated positions and a 2-and-20 fee structure,” Levine
writes. “Index funds will almost necessarily free-ride off the
governance work done by more engaged and concentrated investors.”
His
conclusion is also nonjudgmental but highly revealing of the way
investing works. He talks of the symbiotic relationship between the
alpha- chasers and the index funds.
“Index
funds free-ride off concentrated fundamental investors’ valuation work,
buying stocks at the market price with no view of their own on
valuation; in exchange, though, they push valuations away from
fundamentals and give the fundamental investors more opportunities to
find value,” Levine adds. “And they free-ride off concentrated activist
investors’ governance work, owning companies without bothering to
supervise those companies’ managers; in exchange, though, they encourage
managerial complacency and give the activist investors more
opportunities to lead activist campaigns. Index funds rely on market
efficiency, and Pershing Square helps create it; Pershing Square relies
on market inefficiency, and index funds help create it.”
By:
John Kimelman.
Review: Emerging Market Formulations & Research Unit, Flagship Records.
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