Glasses of water

When a Negative Is Actually a Positive

Glasses of water

Last week, BlackRock Inc, the world’s largest money manager released its quarterly earnings report for the first quarter of 2014. Normally, we don’t pay much attention to these things, but something caught our eye in this Reuters story that we thought was worth sharing.

Fund flows within BlackRock provide a case study of the ongoing migration from active to passive. Institutional investors pulled $12.6 billion from active funds, with the bulk of those outflows coming from active equity and fixed-income. At the same time, they had net in-flows to index funds in excess of $25 billion.

Edward Jones analyst Jim Shanahan had this to say about it:

“That could be a concern going forward. Most of the growth delivered during the quarter was in lower-fee institutional index portfolios rather than actively managed funds and other high-fee products…this concentration of flows in institutional index funds is in my mind a negative development and continues this pressure on weighted average fee rates.”

Although it may not have been his intention, Mr. Shanahan just reinforced the idea that we so often talk about from Step 7: Silent Partners.  Specifically, returns can be thought of as a pie, and when more of the pie is consumed by investment managers and other players such as brokers, the less there is for the investor, who provided all of the capital and took all of the risk.

Furthermore, it is worth noting that Edward Jones was identified by David Swensen1 of Yale as one of the primary practitioners of “pay-to-play” whereby mutual fund companies obtain a “preferred provider” status in exchange for kickbacks, which Swensen deems “a substantial conflict of interest”.

Thus, the flow of funds from high-cost active to low-cost passive could be a negative development for the shareholders of BlackRock as well as the owners of Edward Jones and other companies that benefit from active management.

Of course, we at Index Fund Advisors view it as a positive development, and although all of our clients are shareholders in companies that profit from active management, we contend that the long-term social benefit of investors keeping more of what is rightfully theirs far outweighs the short-term benefit of investment management companies hitting their earnings expectations.

1 Swensen, David F. Unconventional Success: A Fundamental Approach to Personal Investment. New York: Free, 2005, pp. 273-4.