Even Socialists Misunderstand Indexing – The Big Picture

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Bernie, Bernie, Bernie.

Of all the endless Wall Street things to be legitimately angry about – excess fees, leverage, conflicts of interest, risk-taking, bailouts, and everything else to dislike about finance – this has to be the single worst hot take by any politician on either side of the aisle about finance.

Why? Because it shows a fundamental misunderstanding of what’s been going on in the world of investment, and how the indexing revolution has altered the basic premise of who wins and loses on Wall Street.

Unquestionably, the rise of BlackRock, Vanguard Group, and State Street is a good thing – for investors, people’s retirement accounts, and even for Labor (which one would imagine someone like Sanders should support.) These three firms stand in stark contrast to the traditional Wall Street asset managers. Indeed, their rise has dramatically tilted the field in the favor of Main Street against Wall Street, from the big institutions that Senator Sanders despises toward the small investors who makes up much of his core audience.

For most of the 20th century, investing was expensive and complicated. Wall Street’s biggest brokerage firms preyed upon peoples’ hot buttons: greed and fear. They were very good at getting people to chase markets at the top, and panic trade out at the bottom. “Churn ‘em & Burn ‘em” was the strategy to maximize revenue relative to assets under management by the non-fiduciary brokers. Their gains were quite literally their clients’ losses.

Think about how Wall Street makes money: Fund selection, stock picking, sector rotation, market timing, and active trading were just a start. There were also monies to be made in syndicate, IPOs, and secondaries. All of the transactional business that generated big commissions.

But the past 2 decades have seen a move away from traditional Wall Street brokerage, and towards Advisors who are fiduciaries and charge a percentage of assets as a fee. Their interests are aligned, the better the clients’ portfolios do, the more the advisor makes; the worse they do, the less they make.

Typically, on a million-dollar portfolio, the fiduciary advisor (RIA) is charging between 75 and 125 basis points – or $7500 to 12,500 per year. This typically comes with a suite of services including financial planning, tax assistance, insurance reviews, retirement (IRA/401k/403b) planning, estate planning, etc. On the same million dollars, the typical brokerage account used to gross 5 to 10 times that amount — $50,000 to $100,000 in commissions. And, they only provide a fraction of the services.

What seems to be misunderstood by Senator Sanders is how these three giant asset managers took away a lot of this business from the old guard of expensive Wall Street. They did it moving to a very different business model of low-cost passive indexing. They refused to play the wild Alpha-chasing game, and started offering simple, inexpensive ETFs and Mutual funds.

The biggest clients of BlackRock, Vanguard, and State Street are RIAs — typically advisors who mostly use cheap indices to get exposure to broad asset classes for their clients. This is how the “Big 3” (as they are known) amassed nearly $25 trillion in assets: Passive indexing.

Consider the percentage of assets under management at each firm that is passive “buy the entire market” indexes:

Vanguard Group = 79%

Blackrock = 66%

State Street = 64%

Broadly speaking indexers own every stock (excepting the pink sheet or penny stocks). So of course these three “are major shareholders in more than 96 percent of S&P 500 companies.” This is by design. They are major shareholders in the entire market!

And they have bulked up not through nefarious means, but rather, by

What the senator needs to recognize is just how much money these 3 firms have saved small investors over the decades. My colleague Eric Balchunas called this “The Vanguard Effect” and noted in a Bloomberg column that as of 2016, Vanguard saved investors $175 billion in fees since it was founded in 1974. The competition by Vanguard – a mutual which is owned by its clients, and not publicly traded – forced its competitors to cut fees by at least that amount. Its inevitable that within a few years, the total fee savings for investors by Vanguard, Blackrock and State Street will soon be a $1 trillion away from traditional Wall Street.

Senator Sanders should realize this; after all, his disclosures show he too is a Vanguard investor. And recent academic research suggests that active management (including activist investors) results in far worse outcomes for workers and unions from 1982-2015 than it seems passive investing does.

As in so many other things in life, it’s easy to make overly broad declarations, as opposed to more nuanced, intelligent criticism. We perform surgery with a scalpel, not an axe. I wish the good Senator from Vermont would realize this . . .

 

 

Previously:
MiB: Robin Wigglesworth on the Rise of Indexing (November 13, 2021)

Index-Investing Critic Takes Aim, Fires, Misses (December 12, 2018)

Defending Vanguard’s Low Fees (June 2, 2017)

Vanguard Group

Active/Passive Management

Fiduciary Rule

 

 

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