The concentration of economic power has led to spectacular investment returns.
As contrarians, we always ask when will it end and how will it end?
The following article was originally published in “What I Learned This Week” on January 23, 2020. To learn more about 13D’s investment research, please visit our website.
One link that has not received as much attention as it should is the relationship between consolidation and passive investing. The winner-take-all cycle has turned for two decades: Digital natives and sector leaders leverage expertise and spending power to maximize digital efficiencies. They suck in profits from smaller, less nimble old-economy companies. The stocks of the digital natives and sector leaders soar, accounting for the vast majority of growth in the indexes they populate. Inflows to those indexes spike. Active managers have no choice but to capitulate — if they don’t own the digital natives and sector leaders, they will underperform to the point of extinction. More money flows to the already-dominant firms. The indexes become virtually unbeatable. There’s no hidden success stories left to discover. Outflows from active managers continue to accelerate.As of last August, assets in index-tracking equity funds eclipsed assets run by stock-pickers — $4.27 trillion versus $4.25 trillion. Globally, assets managed by index funds now exceed $10 trillion. If the internal index-tracking strategies of sovereign wealth funds, endowments, and pension plans are included in that calculation, the total swells to approximately $20 trillion.It is no coincidence that the meteoric rise of passive investing has coincided with one of the most intense periods of industry consolidation in American history. Roughly 75% of U.S. industries are more concentrated today than they were in the mid-1990s. The top-decile of companies now account for nearly all economic profit — i.e., how much companies earn above the cost of capital (chart below). Study after study has come to dire conclusions about the consequences of this corporate inequality, from wage stagnation to suppressed capital spending, depressed new business formation, and slowing innovation.
Source: Bloomberg Businessweek
....MUCH MOREIndex investing has no doubt thrived because it’s effective — delivering better returns for lower fees, on average. Its continued rise appears unstoppable. At least for now. As Harvard Law professor Einer Elhauge told Bloomberg recently: “Index funds ‘are great for investors…but part of the reason they’re great for investors is exactly because of the anti-competitive effects.’”As we’ve tracked for years in these pages, a backlash against consolidation is coming. The pendulum will swing from wealth accumulation to wealth distribution. Throughout history, it always has when the concentration of economic power reaches an extreme. So far, dysfunction in Washington has stopped action even when it has bipartisan support. But the political chorus remains loud and clear: a reinvigoration of antitrust is required to curb the monopolistic power of tech giants and sector leaders.Now, from the FTC to the Justice Department, attention is beginning to be paid to indexing. And it’s not just about the immense power of the Big Three indexers — BlackRock, Vanguard, and State Street. The fact is, for passive to be systemically healthy, active management must remain vigorous and influential. The market needs price discovery to elevate deserving winners and control euphoria. And companies need active shareholders to encourage competition and provide accountability for greed and indiscretion.At what point has passive grown so dominant, the market becomes dangerously extreme and only offers opportunity to already-entrenched corporate superpowers?Indexing, by its very nature, is biased towards bigness. Retail investors are drawn to mega-cap indexes because they contain brand names they know, trust, and can track just by following the news cycle. Three of the top four ETFs in terms of AUM track the S&P 500. In addition, the more diverse a company’s business and track record, the more it can fit into almost any index construction. In WILTW June 15, 2017, we quoted Horizon Kinetics’ Steven Bregman on this topic:...
