When it comes to investing for the future, financial planners love to tout the merits of index funds. They’re relatively inexpensive, and they allow average-income investors to “buy the market,” providing them with a fairly good shot at generating a positive return over the long term. Their ability to cheaply provide competitive returns means that index funds now comprise almost a third of the US investment market.
But these increasingly popular investment vehicles are not entirely without controversy. While index funds are generating wealth for some, they’ve also been linked to income inequality in the broader economy.
The Problem with Passive Investing
Since index investors are by definition passive investors, they may be less likely to concern themselves with corporate governance questions and other factors that can contribute to income inequality. And corporate governance can have a tremendous power over the economy. For example, poor corporate governance was a causative factor in the Great Recession, according to the OECD. The recession had a devastating effect on average Americans. 401(k)s and IRAs, the main retirement savings vehicles for typical workers, lost $2.4 trillion in the last two quarters of 2008. According to the Atlantic, this loss will contribute to a significant trend of downward mobility during retirement.
Of course, the gap between the richest and poorest Americans is a complex and long-term problem, but the relatively recent growth in index funds may be exacerbating the issue.
Widespread passive ownership of a company, for example, is linked to higher executive pay. This is particularly true for CEOs, who already earn 300 times more than typical workers. A study by the European Corporate Governance Institute found that CEOs who work in industries with widespread common ownership, including through index funds, receive higher pay on average and are more likely to make decisions that are good for their overall industry but bad for their individual company. “[I]f the most powerful shareholders of a firm also own stakes in the firm’s competitors, shareholders want to incentivize managers to compete less aggressively,” the paper’s authors wrote. “Hence, in equilibrium, common ownership decreases the optimal incentive slope on own-firm performance and increases the optimal managerial reward for rival firms’ performance.”
Reduced Competition and Income Inequality
In addition to potentially making the richest Americans richer by increasing CEO pay, there’s evidence that passive ownership could also hurt the poorest Americans by jacking up consumer prices. A paper in The Journal of Finance finds that the cost of airline tickets goes up by 3% to 7% because of common ownership. Another paper indicated that when banks are largely owned by index funds, it leads to increased bank fees and thresholds for interest-bearing checking accounts.
In the end, index funds can backfire on working people. While it gives them a piece of the market, it may also be turning the market against them. For this reason, large-scale shareholders can be a powerful voice at the table. Using tools like proxy votes, large shareholders may be able to force progress on corporate governance issues like CEO pay whereas passive investors cannot.