I am the Kester and Brynes Professor at Columbia Business School and a Chazen Senior Scholar at the Jerome A. Chazen Institute for Global Business.
Despite the well-known advantages of indexing to investors, they add under-appreciated costs to the ecosystem: specifically, index zombies that underperform can continue to hang around as they don't have to fight for capital once they are in the index.
Continuing my series on long-term investing, I wanted to look at how the Big Three index investors (BlackRock, Vanguard, State Street) make money- how much they charge for running money in index funds and more controversially, what is the full "cost" to society for these indexers being passive, both in choice of investments and engagement with management of these companies?
Indexing has become popular on account of three factors. First, the belief that markets are efficient and there is not much to gain by investing in security analysis and security selection. Second, even if significant alpha gets generated by active investors, that incremental return is skimmed by the fund manager via fees. Third, finding managers who can add alpha is very hard, and most investors lack the skills to identify such miracle workers.
Of course, markets are not always magically efficient as this requires hard work of researching the fundamentals related to the economics and corporate governance arrangements, which index funds by their nature avoid. But we will come back to that later. Let us start by looking at the fees charged by the Big Three indexers.
1.0 Minimal expense ratios of index investing
BlackRock's 10-K for the year ended 2022 states that its assets under management at the end of 2022 were $8.6 trillion and revenue was $17.8 billion. Hence, a very crude expense ratio on those assets under management (AUM) works out to 0.29% ($17.8 billion/$8.6 trillion).
Obviously, not all this revenue is earned by the passive side of the business. BlackRock states that revenue from their exchange traded fund (ETF) and indexes that do not rely on ETFs (collectively labeled passive by me) works out to $6.574 billion ($4.345+$0.711+$1.122+$0.396).
On page 3 of their 10-K, BlackRock discloses that of the $8.6 trillion, $5.5 trillion, relates to ETFs and non-ETF indexes. So, the simple "expense" ratio on passive approximates to $6.574 billion/$5.5 trillion or roughly 0.12%. This assumes that BlackRock is not subsidizing its index business with fees earned from its active business. Here, BlackRock charges $12.3 billion to run $3.3 trillion of "active" assets and that works out to an expense ratio of around 0.37%.
Included in the revenue numbers is $599 million that BlackRock earned by lending out securities held. Blackrock states that it had $355 billion of securities lent out as of year end of 2022. BlackRock's equity AUM is $4.4 trillion. Thus, BlackRock appears to lend out 8% of the equity securities under management ($355/4.4 trillion), assuming equities are lent out more often than bonds. On the surface, this sounds relatively innocuous. But, the weird thing is that vote by BlackRock for a long position is implicitly a vote against short position held by the party that has borrowed securities. So, share lending creates its own conflicts for the Big Three.
Although I am technically a shareholder at Vanguard, I, surprisingly, could not find an income statement for Vanguard. Vanguard states that its asset-weighted expense ratio is 0.09% on its website. I could not find financial statements for State Street Global Advisors (SSGA), which runs State Street's index business, to figure out what SSGA charges by way of revenues for their index business. As a first cut, let's simply go with 0.12% expense ratio as what it takes to run passive investments in the public market.
It is tempting to stop here and celebrate the social value added by indexing. And indeed, there is plenty to celebrate. Index investing is a genius innovation of our time as it democratizes access to tax-efficient and extremely cheap way for savers to diversify their bets and transfer wealth across their life cycle and across generations without incurring much time and effort to the research associated with betting on slivers of the public market.
2.0 With great power, comes great responsibility
Collectively, the Big Three owns around 15-20% of every company in the S&P 500. This is a staggering statistic. They often claim that they are "universal owners" and will hold the stock longer than virtually anyone else if the stock is in the index. Even if the stock were to get kicked out of the S&P 500, it migrates down to the S&P 600 mid-cap and of course most likely stays on the Russell 3000 index. And the Big Three hold positions in these smaller indexes as well.
One of the most worrisome aspects of indexed business is the disconnect between the owner and the manager and the misallocation of capital that ensues. I wonder whether the Big Three have the resources to really engage with companies to correct such misallocation given that they cannot simply sell the stock to register their protest.
I believe that The Big Three, however, are primarily in the business of selling low-cost funds. Engagement and research required to understand the deeply idiosyncratic reporting and governance problems of a firm can be very expensive, and the business model of the Big Three is simply not set up to incur such expenses.
You might retort, "Aren't the Big Three looking at governance issues and a broad set of risk factors, only some of which are ESG stuff, that explain poor performance or could lead to poor performance. Why do they even bother with this?"
My response is that the Big Three or no single institution can fully research the 4000 plus stocks that the Big Three hold. The engagement work they do undertake is partly meant to counter criticism from stakeholders that they are too passive. Whether such engagement is effective is an empirical question that I am investigating with co-authors.
BlackRock has publicly disclosed that it employs 70+ executives in its engagement team. (I could not find comparable data for Vanguard and SSGA.) I wanted to estimate how much BlackRock spends on its engagement team. As per its latest proxy statement, the median employee pay at BlackRock is $154,000. Let's double that to, say, $310,000 and multiply that by say 75 employees in the stewardship team. That works out to $23.5 million. On an asset base of $8.6 trillion, engagement thus accounts for roughly 0.0002% of the expense ratio. Is that enough of an investment in gathering and analyzing governance information for the stocks held by BlackRock? I don't know what these numbers look like for Vanguard and State Street (which is strange), but I would assume they are in a similar ballpark or even lower.
Bottom line, you can either govern by picking the "right" stocks as done by long term active managers, who pick well-run companies and/or "engage" and get management to change its errant ways, as done by activists and a few long-term active managers. The Big Three cannot pick the "right" stocks as that is decided for them by the index maker. Why?
Consider what it takes to get into the S&P 500, the key index. The S&P has an anonymous committee that decides which of the stocks eligible under the following criteria, based on size, liquidity, profitability, how "American" they are, to get in: (i) the firm is domiciled in the U.S and derive most of its revenues and assets from the U.S.; (ii) $12.7 billion or more, as of January 4, 2023, in market cap of equity; (ii) at least 75% of its market cap trades annually; and (iii) over the last four quarters and in the most recent quarter, the firm needs to report positive income.
As an aside, the discretion itself opens the question of whether S&P is an "actively" managed benchmark. Hence, one can always ask whether indexing linked to the S&P 500 is truly passive investing. The Russell 1000 index, on the other hand, is based purely on an algorithmic rule. They pick the 1000 most valuable stocks based on the following criteria: (i) U.S. stock; (ii) minimum capitalization of $30 million; and (iii) at least 5% of the float must be available for trading. The index is rebalanced every June.
Anyway, coming back to the main point, I argue that the Big Three do not have the resources to invest in fixing broken management as they are in the business of selling very low-cost funds. Hence, I conjecture that the grunt work of governing these companies usually gets delegated to someone else. ISS and Glass Lewis, the proxy advisors, are the two most prominent intermediaries that counsel asset managers on proxy voting. So, this pushes the analysis problem one level below to these proxy advisors.
3.0 Proxy advisors
The Big Three do not explicitly state that they rely on these proxy advisors. Ideally, I'd like to know how much ISS and Glass Lewis are paid, if at all, by the Big Three. But those numbers are not publicly available. ISS's Linked In page claims that they employ approximately 2820 workers. Glass Lewis is smaller, and they seem to employ 394 people as per their Linked In page.
I am sure the proxy advisors have stopped egregious governance abuses via their programmatic approaches to boards (more than 4-5 public boards are considered over-boarding) or compensation (no willynilly repricing of executive stock options, for instance) via their published voting guidelines.
But the devil in governance lies in the detail. Do ISS and Glass Lewis have the resources to invest in understanding that level of detail? I could not find financial statements for ISS or Glass Lewis to understand the economics of their business. Moreover, in at least a couple of my papers (see here and I can send the other two papers if someone wants them), I cannot find evidence that ISS's recommendations cannot seem to be able to detect firms where CEOs get paid handsomely when investors interests are hurt.
In essence, the Big Three own but are not really set up to properly oversee and evaluate the corporate governance of the companies in their portfolios.
Let me pause here and continue the rest of the story in part 2. Next week, I will identify index zombies and why the inevitable "why doesn't someone arbitrage them" statement does not quite work.
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