Princeton academic Burton Malkiel is worried that FDIC rules against concentrated ownership will ruin index funds, but there are much larger problems at stake.

Burton Malkiel on Index Funds: The FDIC May Spoil the Party

We discussed Princeton academic Burton Malkiel’s continued cheerleading for passive investing here at Passive Parabellum, despite the mountain of evidence, academic and in practice, that indexing is destroying market efficiency and price discovery. Recently, the esteemed professor wrote in an op-ed in the Wall Street Journal that the FDIC’s rules against concentrated ownership in bank stocks may hurt the indexing craze.

As Malkiel explains, “The Vanguard Group, pioneer of indexing, owns 13% of the capitalization of regional banks First Third Bank and Zions Bank and more than 9% of the megabank JPMorgan Chase. BlackRock and State Street have holdings of similar magnitude.”

Burton Malkiel on Index Funds: Worried about the FDIC When The Flaws of Passive Investing Are Much Greater

However, the professor has no reservations about this large concentration of ownership. His argument is based on the fact that index funds do not desire to influence or control the bank stocks that they own. While we would agree with that assessment, there is the larger question of how the rise of passive investing has harmed American corporate governance. Since index funds own virtually all stocks, they are less interested in malfeasance or underperformance at any one particular firm.

Contrast this with an active investor, who has more at stake in an individual position and knows that company’s operations and management team more intimately. He may engage in talks with management to improve results, question their compensation, or even engage in public letter-writing or activist campaigns to fight for change. In a way, these managers are policing corporate America and keeping executives honest, because their economic interests are at stake. This is largely lost in the era of passive investing, as David Einhorn of Greenlight Capital recently explained.

Overall, the corporate governance ramifications are small compared to the price and valuation-distorting aspects of indexing. It continually mystifies us that Burton Malkiel and other academics turn a completely blind eye to the rapidly growing body of academic papers that detail the significant harm passive funds are inflicting on capital markets. Of course, we should not be so naive that these individuals would actually seek the truth and repudiate decades of their own economic scholarship.

Just like stock traders, academics frequently talk their own book, facts be damned.


Leave a Comment

Your email address will not be published. Required fields are marked *