Where the Fisch, Hamdani, and Davidoff Solomon Theory of Passive Investors Goes Awry

President Reagan once said, “I’ve heard that hard work never killed anyone, but I say why take the chance?”  In a recent paper, professors Jill Fisch, Assaf Hamdani, and Steven Davidoff Solomon (hereafter “FHDS”) argue that passive investors – the big index funds that many of us invest with – have no choice but to work hard. FHDS argue that passive funds must compete with active funds for investors by engaging with portfolio companies, and, most importantly, that this engagement is designed to improve the performance of their passive funds. As FHDS put it, “Our fundamental insight is that because of the competition between active and passive funds, index funds need to monitor their portfolio companies and to exercise their governance rights in an informed manner to promote firm value.”

I have written a short response to the FHDS piece. There are two points where I agree strongly with FHDS. First, in working to understand passive investors, we should, given the evidence so far, be skeptical of research suggesting that their power and lack of incentive to fulfill their corporate governance duties make them a threat to the welfare of corporate America. Second, and a fundamental insight of FHDS’ approach: we can probably gain useful insights from exploring the competition between passive and active funds.

But I believe that FHDS have missed four important points. First, FHDS assume a problem that evidence suggests does not exist: that active managers have a comparative advantage that passive managers must overcome. To a financial economist, a peculiar part of the FHDS argument is its premise that active managers’ advantage derives from their ability to pick stocks, buying the ones they  believe will do well and selling the ones they think will do poorly. But this assertion conflicts with virtually all evidence demonstrating the inferiority of actively-managed funds. No evidence demonstrates that funds  run by stock brokers, managers of active mutual funds, or even the best- known hedge fund managers reliably beat passive strategies. This accumulated evidence of underperformance has generated a strong shift to passive investing. The FHDS theory rests on the false premise that passive managers are competitively disadvantaged relative to active funds; they are not.

Second, FHDS do not mention that the largest passive investors are also some of the largest active investors, and they stand to make much more money improving the performance of their active strategies than of their passive strategies. This omission is problematic for two reasons. First, a fund like BlackRock or Vanguard can probably make much more money putting another dollar into an active product than five or more dollars into a passive index. Moreover, improving a passive index by choosing better index components helps competitors that also use that  index, while any improvements in an actively-managed product accrues disproportionately to the fund. Improving the performance of passive rather than their active products simply does not pay and may end up helping competitors.

Third, while FHDS emphasize the corporate governance initiatives of passive investors as evidence of their competitive efforts, there is no reason to believe that such efforts are aimed at improving passive funds relative to active funds. The large institutional investors that invest with the large passive providers may enjoy stories of the good they believe index providers do in advocating for corporate governance improvements. The reality is, though, that corporate governance initiatives have little effect on financial performance. Further, while index funds do sometimes cooperate with hedge fund activists in trying to increase share value, any increases accrue to all index providers.

Finally, but most important, I believe that FHDS have ignored the elephant in the room: evidence that the superiority of passive strategies over active funds comes from broad-based and sticky investment that raises the probability of capturing the returns of the handful of winners that drive equity returns. The tendency of active equity managers to underperform a passive benchmark index was long an ignored mystery. After all, it is one thing for active equity managers to fail to beat the benchmark index, since that may imply only a lack of skill. It is quite another to find that active equity managers fail to keep up with the benchmark index, taking into account fees and trading costs, since that implies that active equity managers are doing something to cause underperformance. Researchers are now realizing that indexing’s advantage is not only lower fees or trading costs, but the underemphasized empirical fact that the best performing stocks in a broad index often perform much better than the other stocks in the index, so that average index returns depend heavily on a relatively small set of winners. The first published result on this suggestion was by professors Ikenberry, Shockley, and Womack (Why Active Managers Often Underperform the S&P500: The Impact of Size and Skewness, 1 J. Private Portfolio Mgmt. 13 (1992)). More recently, I developed a model with my co-authors, Nick Polson and Jan Hendrik Witte, showing how randomly selecting a small subset of securities from an index maximizes the chance of both outperforming the index—the allure of active equity management—and underperforming the index, with the chance of underperformance  larger than the chance of overperformance (Why Indexing Works, 33 Appl. Stochastic Models in Bus. and Industry 690 (2017)). FHDS do not consider this evidence, and err as a result in assuming that indexing has no advantage over active management other than lower fees and trading costs.

Active managers must overcome an inherent disadvantage: Most corporations perform poorly over time, as shown most convincingly in the work of Hendrik Bessembinder (Do Stocks Outperform Treasury bills?, Journal of Financial Economics, forthcoming (2018)). Professor Bessembinder shows that the best-performing 4 percent of listed companies explain the net gain for the entire U.S. stock market since 1926, while other stocks collectively only matched the return on Treasury bills. As it turns out, passive investing has considerable advantages over active investing. Any theory that rests on the assumption that passive investing is constrained rather than advantaged will have trouble contributing to an understanding of the economics or regulatory implications of its effects.

Passive investing is increasing as a percentage of assets under management and may have unintended effects in capital markets and implications for corporate law and securities law. But it is unlikely that is because passive investors have the incentive to behave as FHDS suggest. The crucial premise of FHDS’ theory is that passive funds have little ability to compete with actively-managed funds that can trade in and out of securities. But that theory ignores the evidence that active managers have no competitive advantage to start with, fails to explain why funds like BlackRock and Vanguard would prefer to enhance the performance of commoditized index funds rather than their active funds that have fees an order of magnitude higher than passive products, and does not explain why a focus on corporate governance initiatives would provide any advantage over active funds. It may simply be the case that all you need with passive is to be passive.

This post comes to us from J.B. Heaton, a business law fellow at the University of Chicago Law School.

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