David Winters (Trades, Portfolio) discussed why he believes passive investing doesn't offer all the benefits it advertises on Tuesday in an address to the CFA Society in New York.
In the talk titled “The Hidden Costs of Passive Investing,” the founder of the actively managed Wintergreen Fund (Trades, Portfolio) said passive investing had transformed over the past 40 years when index investing was introduced as a means of buying a slice of an index at a low cost. As inflows to passively managed index funds mount – with $500 million in cash inflows in 2016 versus more than $300 million flowing out of active funds – investors have incurred both hidden expenses and risks, he said.
Dilution
One of the largest risks is that the advertised low fees, averaging around 0.04%, are paid to sponsors of index funds, but proxy voting procedures can increase that number. Executive compensation plans in the form of bonuses, options or deferred stock, for instance, can dilute shareholders. Comparing them to an algorithm, Winters said that companies vote in favor of executive compensation plans 97% of the time.
“That is money that is an actual real expense that comes out of investors’ pockets,” he said.
Buybacks
He also raised the question of whether company boards implement share buybacks in part to offset the dilution executive compensation plans can have, which keeps it from affecting reported earnings and financial results. The dilution can increase the fees the investor is really paying.
“We’ve all been trained that buybacks are good for shareholders because they retire shares, they use excess cash,” Winters said. “But what we realized as we dug into this is that buybacks, 54% of them in 2016, were actually being used to offset these executive compensation plans.”
Winters’ study found that together, advisory fees, dilution from compensation and buybacks to offset dilution cost investors 4.3% on average.
Other factors
Market weighting, he said, could pose a danger, as ETFs purchase more of the stocks that do well. The share of passively managed assets in U.S. markets reached 40% of total assets in 2016.
“Effectively what you’ve seen is the transfer of control through the proxy vote of the S&P 500 to passive investors,” he said.
The 10 momentum stocks leading the bull market 75% of the time, including Starbucks, Amazon and Apple, have driven ETF performance, he said. The force of the rise of the stocks has led to a market that relies on momentum rather than fundamentals.
Last, margin debt has risen to record levels, as investors have used it to fuel the bull market. The increased debt could make any sell-off that may occur more intense, he said.
Watch
Watch the replay of Winters’ presentation here.
