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Thursday, January 28, 2016

What Happens When Index Funds Control Corporate America?

News summary by MFWire's editors

"What Happens When Index Funds Control Corporate America?" "Is There an Index Fund Bubble?"

William Ackman
Pershing Square Capital Management
Chief Executive Officer, Portfolio Manager
Those two questions come from outside the mutual fund business, from a famed, and recently stumbling, activist hedge fund titan. Yesterday Pershing Square Capital Management founder Bill Ackman included those two questions as sections in his annual letter to shareholders, after what turned out to be the worst year performance-wise in the firm's history. (Pershing Square had $13.95 billion in AUM last month and Ackman founded it in 2004.)

Ackman worries about the corporate governance perspective of index fund firms. He notes that in one of Pershing Square's activist fights "one of the largest index fund managers personally attended" a Pershing Square presentation while "certain other index fund managers ... did not take this issue seriously [and] wouldn't even take a meeting on the issue."

Though Ackman stops short of crying "Index fund bubble!", he comes close. He likens the recent popularity of index funds with the technology bubble that grew in the late 1990s and popped in 2000. He sees strong net flows into index funds, pushing the indexes' component companies' shares to be overvalued. And overvaluation is not-so-subtle code for "bubble that bursts sooner or later."

Yet there are secular trends driving the rise of passive investments, like the relentless push for lower costs (especially in the fiduciarily-governed retirement plan marketplace) and the shift away from commission-based compensation models for financial advisors (low-cost index funds have no built-in room for commissions). And the rise of index funds and ETFs also ties into the rise of a different layer of active management, namely model portfolios and so-called ETF strategists. Third-party managers increasingly use index funds and ETFs as underlying components of their actively-managed, tactical strategies, and broker-dealer homes offices do the same with active models, used by thousands of their FAs.

On the flip side, the tailwind of the post-financial crisis bull market is no longer a potential boost to passive funds. There is no more rising tide to lift all asset management boats, at least not for now.

And though passive investments are bringing in the big net-flow bucks, active mutual funds still have double the assets of their passive peers. Per Morningstar's latest estimates, U.S. mutual funds held $16.724 trillion at the end of 2015: $4.527 trillion of that, 27.1 percent, was in passive funds; $2.76 trillion, 16.5 percent, was in money market funds; and $9.437 trillion, 56.4 percent, was in active, long-term funds. 

Edited by: Neil Anderson, Managing Editor

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