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Index Funds Are the New Kings of Wall Street

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09/18/2019 | 05:45am EST

By Dawn Lim

Money managers that mimic the stock market just became the new titans of the fund-management world.

Funds that track broad U.S. equity indexes hit $4.27 trillion in assets as of Aug. 31, according to research firm Morningstar Inc., giving them more money than stock-picking rivals for the first-ever monthly reporting period. Funds that try to beat the market had $4.25 trillion as of that date.

The passing of the asset crown is the latest chapter in one of the most dramatic transformations in the history of financial markets. In the past decade, $1.32 trillion fled actively managed U.S. equity mutual funds and exchange-traded funds as nearly $1.36 trillion was added to low-cost funds that mimic market indexes.

That shift lowered the price of investing for individuals, reduced the influence of stock pickers and turned a handful of Wall Street outsiders into the biggest power brokers in the industry.

Indexing giants such as BlackRock Inc., Vanguard Group and State Street Corp. now wield considerable power over corporate America and can cast pivotal votes that determine everything from who sits on a company board to how executives deal with issues ranging from climate change to pay equity.

The rise of indexing has attracted scrutiny from those who are worried market-mimicking funds could distort prices and exacerbate market turbulence. Index giants have so far dismissed those concerns as fear mongering as they continue to grow.

"Let's first define when people talk about indexing getting big," Vanguard Chief Executive Tim Buckley said in May. "It's not big enough. There's still too many people getting ripped off by high-cost active."

The Morningstar data covers a slice of the mutual fund and ETF world focused on U.S. equities. Industry trade group Investment Company Institute said its own data showed assets in U.S. equity index mutual funds and ETFs haven't surpassed actively managed U.S. stock funds.

Index funds are a long way from dominating the whole stock market. U.S.-focused index equity funds make up nearly 14% of the American stock market, up from roughly 7% in 2010, according to the Investment Company Institute. Index funds generally contribute up to 5% of U.S. stock-market trading, economists estimate.

Old-fashioned money managers aren't willing to relinquish their crown so easily. They are experimenting with new fee structures, leaning more heavily on data science and turning to illiquid bets in a bid to keep customers and attract new ones. Some also are using index funds to build their portfolios.

"I look at it much in the same way as Roger Federer looks at Novak Djokovic," said Andreas Utermann, chief executive of Allianz Global Investors, in a nod to two tennis titans. "It helps us to improve our game."

The challenge to traditional stock pickers began more than four decades ago with Vanguard founder Jack Bogle's introduction of the first index mutual fund for ordinary investors in 1976. His idea, which was to allow everyday investors to essentially own a stake in the entire market at minimal cost, was initially scorned by Wall Street.

Another threat emerged in the 1990s with the advent of exchange-traded funds. These are collections of stocks or bonds that trade on exchanges and give investors rapid exposure to markets.

Following the 2008 financial crisis, more customers pulled their money from actively managed funds when they realized pricier managers had failed to protect them from the market rout. The outflows snowballed as stock pickers struggled to beat one of the longest bull runs in history. More than 80% of U.S. actively managed equity funds underperformed the S&P Composite 1500 in the decade ended 2018, according to S&P Global.

Three firms -- BlackRock, Vanguard and State Street -- were major beneficiaries of the shift, cementing a roughly 80% share of the index fund market. BlackRock and Vanguard collectively took in a daily average of roughly a billion dollars in total net flows last year. State Street's SPDR S&P 500 ETF Trust was one of the most-traded securities in the past year.

These firms face new questions as their power intensifies. One is how they should wield their newfound influence over companies. BlackRock, Vanguard and State Street hold about 20% of the S&P 500 through funds they manage, according to FactSet. Big indexers were key votes in a landmark shareholder victory in 2017 that pushed oil giant Exxon Mobil Corp. to explain the impact of climate-change rules.

"The rise of passive investing raises the corporate governance challenge of the 21st century," said Securities and Exchange Commission Commissioner Robert Jackson in a statement. "It can give a few individuals influence over the outcome of elections in the corporations that control the economic future of millions of American families."

Others question if index funds are equipped to watch over all the companies in which they invest. "They have driven real governance improvements," said Lyndon Park, who heads a business at ICR that advises companies on shareholders. "But given the large universe they invest in, their stewardship teams can't follow every company and sector-specific issue." Indexing managers from BlackRock to Vanguard have been expanding their stewardship teams in recent years.

Lynn Blake, who heads equity indexing at State Street Global Advisors, adds that the firm has to be selective about which companies it meets and that it uses technology to augment the reach of its 12-person stewardship team. "We will hold positions for a very long time," she said. "We want to work closely with directors and boards so they understand our point of view."

Another concern is the ripple effect index funds have on the stock market. Some studies show that company share prices get a boost when they are added to major benchmarks, and stocks can be vulnerable to short-term price swings as money moves in and out of index ETFs, especially for shares that are bigger parts of indexes and less traded.

Asset managers that run index funds say fears that the strategy could cause widespread market disruptions are overblown. There are hundreds of index products and they don't all trade in tandem. Moreover, buying and selling by index funds reflects real shifts in sentiment by investors, and stock prices should respond regardless of what kind of fund is used.

But the apostle of the index fund became more concerned about the unintended consequences of indexing's success in his final years. If index giants kept growing at the same clip, it would be a matter of time before governments tried to break them up, the late Mr. Bogle told close associates. He worried this would put the future of the index fund in jeopardy.

--Jason Zweig contributed to this article.

Write to Dawn Lim at dawn.lim@wsj.com

Stocks mentioned in the article
ChangeLast1st jan.
BLACKROCK, INC. 1.31% 490.96 Delayed Quote.24.98%
DJ INDUSTRIAL 0.80% 28004.89 Delayed Quote.20.05%
EXXON MOBIL CORPORATION 1.01% 69.19 Delayed Quote.1.47%
NASDAQ 100 0.70% 8315.523102 Delayed Quote.30.46%
NASDAQ COMP. 0.73% 8540.828717 Delayed Quote.27.79%
S&P 500 0.77% 3120.46 Delayed Quote.24.48%
STATE STREET CORPORATION 0.40% 72.54 Delayed Quote.15.02%
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Financials (USD)
Sales 2019 11 626 M
EBIT 2019 2 770 M
Net income 2019 2 107 M
Debt 2019 17 710 M
Yield 2019 2,73%
P/E ratio 2019 12,9x
P/E ratio 2020 11,6x
EV / Sales2019 3,79x
EV / Sales2020 3,78x
Capitalization 26 377 M
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