Should passive investments be taxed?

Are index funds parasites free-riding on the active stock pickers who do the hard work of identifying value? One controversial proposal goes to the heart of the matter…

The ongoing debate as to how to rejuvenate London’s flatlining financial markets continues to yield intriguing proposals for reform. Not least the suggestion that a transaction tax should be levied on passive investments.

Last week Chancellor Jeremy Hunt used his Mansion House speech to announce a set of sensible, if low key, initiatives designed to begin the process of rejuvenating UK exchanges.

The most significant was a compact signed by major pension providers to commit 5% of their default funds for defined contribution (DC) pension savers to unlisted equities, which could unlock up to £50bn of investment in growing companies by 2030. DC funds currently invest only 0.5% of their estimated £500bn of assets in unlisted UK enterprises, depriving emerging companies of capital, and deterring them from joining London’s exchanges. The number of stocks listed on the LSE has fallen from from 2,400 in 2015 to less than 2,000 today: remarkably, Apple, the world’s largest company valued at some $2.3tn, is now worth more than the entire UK market. The Chancellor also announced proposals to pool defined benefit pension funds to encourage them to invest at scale, and to open up investment research on small caps to retail investors.

A transaction tax on index funds

One of the more interesting of the many contributions to the debate was an article, published in The Times shortly before the Chancellor’s speech, by Simon French, Chief Economist and Head of Research at Panmure Gordon. Freely available on the Panmure website, it’s a thoughtful piece suggesting reforms that extend the Mansion House proposals. One is that UK-listed investments should qualify for ISA tax relief, another that British public sector pension schemes should be obliged to allocate a minimum amount of their capital to UK-listed, or UK-domiciled investments.

But — to use French’s understated words — ‘perhaps most contentiously’ the article went on to suggest taxing the purchase of passive investments, which, typically charging below 10 basis points (bp) a year, are much cheaper than active funds, which usually levy fees in the region of 75 bp to 125 bp. For French, index funds contribute nothing to ‘price discovery’, thereby undermining ‘the key social function of financial markets’: the channeling of capital away from overvalued stocks to productive and innovative companies. By closing the fee gap a transaction tax would encourage active stock selection, ensuring more investor capital reached undervalued companies. The money raised from the tax could be used to kickstart a UK sovereign wealth fund that would invest further capital in promising British firms.

Parasites ‘devouring capitalism’…

French’s unusually direct proposal cuts to the heart of the industry’s concern — and resentment — regarding the runaway popularity of passive funds. By free-riding on the work of active investors, the argument goes, they erode the capacity of the markets to identify value. The share of securities owned by index funds is keenly disputed, but credible research by the Harvard Business School suggests that passive investors held nearly two-fifths of the US stock market in 2020, more than twice the share indicated by previous estimates.

Another paper, from the UCLA Anderson School of Management, contends that the passive juggernaut is distorting price signals. Examining trades by institutional investors, the research maintains that the rise in passive investors’ share of the market over the past 20 years has generated ‘substantially more inelastic aggregate demand curves for individual stocks’. Or more plainly, as one of the authors put it: ‘not enough people are showing up to trade. You have less information in the market, less aggressive trading, less accurate prices and a more volatile market.’

Paul Singer, founder of the Elliott Management Corp hedge fund, spoke for many active advocates back in 2017 when he declared passive investment was ‘devouring capitalism’. For Singer, ‘what may have been a clever idea in its infancy has grown into a blob which is destructive to the growth-creating and consensus-building prospects of free-market capitalism. This “overgrowth” is a drag on the power of capitalism to adapt, to continually strive for excellence, efficiency and creativity and to deliver goods and services for citizens in the manner in which it has done for the last couple of centuries.’

More recently, a Financial Times commentary by Simon Edelsten, a manager of the Mid Wynd International Investment Trust and the Artemis Global Select Fund, made a somewhat more understated case for the distinctive virtues of active management. As well as facilitating price discovery, by taking a close interest in particular firms good actively managed funds can afford investors greater corporate oversight. And by hand picking stocks according to fundamentals they can smooth portfolio volatility, avoiding the bubble stocks that passive funds have no choice but to buy. Edelsten is unapologetic about the slow and steady performance of funds oriented towards value: ‘While we wait for sense to prevail, their short-term performance will be poor — you should perhaps be disappointed if it was not.’ Fundamentals — eventually — win when the market turns against overinflated stocks.

There is even some cause to challenge the easy claim that passive beats active hands-down performance wise. One recent analysis of the performance of Luxembourg and Ireland-based UCITS equity and fixed-income funds between 2008 and 2020, found that share classes accessible to institutional investors outperformed passives by 0.56% a year before the impact of costs was included, coming ahead in 25 of the 35 categories studied. The issue for retail investors wasn’t performance, but higher fees.

An inconclusive case

But of course fees matter. And the accumulated evidence doesn’t lie. Suffice to say, over the decade to mid-2022 only 20% of global equity funds beat the market, and a mere 12% of US equity funds. Last year, despite turbulent market conditions supposedly favourable for active stock picking, the average US stock picker lost 21% compared to the broad S&P Composite 1500’s 18% decline. Small-cap funds lost 21% compared to a 16% decline for the S&P’s small-cap index. And the average global fund lost 22% against the market’s 17% fall.

But setting aside performance, and returning to the point at issue: do index funds undermine the market’s capacity to identify value? The picture is unclear, but there are good arguments to suggest that they do not.

One reason is technical. In their lucid manifesto for passive investment The Incredible Shrinking Alpha Andrew Berkin and Larry Swedroe cite an intriguing study by Darius Palia and Stanislav Sokolinski indicating that passive investing actually contributes significantly to market efficiency by facilitating short selling, now widely recognised as an important mechanism by which the market identifies and weeds out overvalued stocks.

Borrowing securities to sell is a risky business. Short sellers often struggle to access adequate stocks to borrow for the purpose of shorting, and continually run the risk that such securities are recalled before the strategy pays off. Studying the 10 years between 2007 through 2017 Palia and Sokolinski found that passive funds participate more aggressively in stock lending programmes than active funds and other non-mutual fund lenders. Rather than simply sit on their millions of shares passive managers loan them out to secure a significant source of additional revenue. By making it easier for short sellers to borrow more easily, at lower prices, and for longer time periods, they facilitate price discovery.

The other reason is intuitive. As more and more retail investors embrace passive funds, the quality of decision-making within the active market is increasing. Stock picking is ever more the province of dedicated private investors, fund managers, institutional investors, and high-frequency traders, all of which still find the field lucrative. Trading volumes have set new records rather than declined, with listed US asset managers recording an average profit margin of almost 26% in 2021, more than twice the S&P 500’s average.

A decline, then, in the number of stock pickers does not mean that the market’s capacity to identify value is deteriorating. As less skilful investors depart, there are more opportunities for the professionals. But that doesn’t mean it is getting easier to beat the market. That is a matter of relative rather than absolute skill. With a small ‘pool of victims’ — less skilled investors who can be easily outwitted — the best investors are left to scrap among themselves for alpha.

But what if passive investing did gradually drive out stock pickers? Wouldn’t something have to be done — like the imposition of some form of tax? A commentary published in the February 2017 issue of The Journal of Investing, Brad Cornell, cited by Berkin and Swedroe, suggests how market efficiency might persist even in that extreme scenario.

In brief, issuers, those who alter the number of shares on the market through IPOs, secondary issuances, buybacks, mergers and delistings, would assume the role of pushing the market towards efficiency. Share issuances and buybacks, initiated by information available only to insiders, give clear signals about the status of a company, which are automatically reflected in passive funds’ holdings. Repurchases and new issues tend to push the price securities towards their fundamental value.

Cornell argues that there is ‘empirical evidence that even in current markets, let alone in hypothetical markets where passive investors predominate, it is issuers — not active investment managers — that play the central role in maintaining market equilibrium.’ He notes, for example, that the volume of IPOs and seasoned equity offerings peaked at roughly the same time as the NASDAQ towards the edge of dot-com boom that ran from 1997 to 2000. That was a better indicator that the market was about to collapse than short selling, which was actually declining, failing to anticipate the turn. It was the issuers who brought the market to equilibrium.

A complex picture

The passive-active debate, as again demonstrated by the response to Simon French’s article, raises strong emotions. On the one side, there is frustration that passive funds are riding on the price discovery work done by others. On the other, there is incredulity that active funds continue to charge much higher fees even when falling well short — in the aggregate — of market indices.

The reality is nuanced. Good active managers can offer certain advantages: judicious stock selection, corporate overstock, less volatility. But they charge for it. Over time, the evidence is that the market wins, cheap index funds beating expensive active managers. And the argument that passive investment is undermining market efficiency is far from conclusive. Certainly not, at least, to justify the imposition of a tax on the funds most likely to yield decent returns for ordinary investors. Reforms to rejuvenate UK markets are commendable, but there are other ways to do it.

The image is a collage based on photos by Nick Chong and Erik Kants on Unsplash.