Rise of passive investing could harm Silicon Valley startups

The tremendous growth of index funds could stifle growth of startups and harm innovation as massive amounts of money flow into company stocks regardless of their individual performance.
Written by Tom Foremski, Contributor

For decades it's been known that index funds such as the S&P 500 outperform the vast majority of actively managed mutual funds picking stocks.

Wall Street's algorithms finally noticed and now vast amounts of money have moved into index funds and they continue to do so at an increasing volume.

A recent report from Bank of America showed that Franklin - the largest operator of index funds - owns at least 5% of 490 companies in the S&P 500 compared to about one quarter or 119 companies seven years ago.

The trend is your friend when it comes to Wall Street and that is why even larger amounts of money are heading into index funds which now account for about half of the stock market.

Profitless picking...

It is called called passive investing because it requires no stock picking or timing of markets. It does not matter if any of the index stocks are in trouble because they will be bought along with the winners - a rising tide lifts all boats.

The Index funds' lack of management involvement means it has very low fees and the money always matches market performance - which the vast majority of stock picking mutual fund managers cannot do on a consistent basis.

This scenario is great for the average investor because they are guaranteed the market performance. But this passive investing strategy does not discriminate it rewards every company in the index regardless of their brilliant strategy or their outstanding executive leadership - you just have to be one of the index companies.

It's a bad situation:

- How will startups grow and then IPO and be rewarded by investors because they become major disruptors in their markets- if they aren't part of the market index?

- How will venture capitalists recoup their startup investments at a premium if the IPO window is additionally occluded by the lack of Index membership?

- Why invest in innovation to out-compete rivals if rivals get the same investment funds regardless of their research and development investments?
Several observers have pointed out the dangers of passive investing:

Evan Horowitz at the Boston Globe:
Smart investors may be killing capitalism

Think Apple and Microsoft are fierce rivals? Maybe, but it turns out they have a lot of the same owners... What they gain on one side of the investment ledger, they lose on the other.

Stephen Gandel at Bloomberg News:

Don't be smug, ETF investors. You may just ruin the market and kill new public offerings

With fewer shares to trade, once more are locked up in ETFs and index funds, even small trades could cause bigger price swings.

The volatility is caused by fewer shares available for trading which means index stocks become easy to manipulate.

And there are lots of rewards for chief executives to pursue this strategy with surveys showing 25% higher salaries for companies in an index and ten times faster compensation.

This particular trend will not reward innovation - it favors the incumbents: the index dwellers - and that's very bad for Silicon Valley and its tens of thousands of startups.

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