Direct indexing and shareholder democracy

Become a Patron!

The late Paul Volcker is famously said to have quipped that he hadn’t seen a worthwhile financial innovation since the ATM, which makes him slightly more cynical than even I am. In fact, I think we’re on the brink of a real revolution in shareholder democracy.

Mutual funds and direct ownership are competitors

Vanguard has offered low-cost, commission-free, passively-managed mutual funds my entire adult lifetime, which makes it easy for people of my generation and younger to dismiss the seriousness of the problem Jack Bogle solved. After all, stockbrokers and mutual funds long predated Vanguard, so a savvy investor always had the option of either opening a brokerage account with a local provider and buying an appropriately diversified basket of stocks and bonds, or selecting an appropriately diversified mutual fund from one of the many available firms.

The obstacle was cost: with commissions as high as $75 per trade, buying and selling a single stock, let alone a basket of stocks, was enormously expensive: you could spend almost $2,000 in commissions when buying just 25 stocks. Once you owned shares, of course, the ongoing cost to hold them was negligible.

Mutual funds offered a different tradeoff. By paying a single up-front commission, you could buy into a basket of “expertly-managed” stocks that would be rebalanced at the manager’s discretion. Of course, expert management isn’t cheap, so you’d also pay an ongoing fee to keep the lights on at headquarters and return profits to the fund company’s shareholders.

We don’t normally talk about it this way, but these models are in competition: stockbrokers offer wealthy investors and institutions the ability to save on their ongoing holding costs by charging large up-front commissions, while mutuals funds appeal to middle-class investors willing to pay higher ongoing costs in exchange for a smaller up-front investment.

In the context of this competition, Bogle’s solution was elegant: fire the company’s shareholders (by making Vanguard’s mutual funds the owners of the company itself), fire the experts (by offering passively-managed, market-capitalization-weighted funds), and pass the savings on to the shareholders in his mutual funds.

Bogle won the first round, and Vanguard’s investors have benefited enormously. But today, we’re seeing the early stages of the stockbrokers’ revenge.

Fee-free trading was a breakthrough; direct indexing of fractional shares will be a revolution

I’ve written plenty of times about Robinhood, the fee-free trading app. It’s had some growing pains, both regulatory and technical but it has always fulfilled its essential promise: commission-free buying and selling of stocks and ETF’s.

As a company, Robinhood is as hopeless as Uber, incinerating millions of dollars in Saudi oil profits with signup bonuses and operating expenses that their revenue can’t even begin to cover, praying to be acquired by a real company before the next crash.

But as an idea, Robinhood was a brilliant strike back against Bogle’s triumph: if trading is commission-free, and holding shares is free, then what advantage does a mutual fund have over ownership of the fund’s underlying shares? Ownership of shares gives investors the right to vote at shareholder meetings, and it allows precision tax-loss harvesting, while even Vanguard ETF ownership only allows you to vote your shares of the mutual fund, not the underlying companies, and by blending together the performance of its constituents limits the availability of tax-loss harvesting.

Robinhood offered one solution to one problem, but it’s not enough, for the simple reason that it does not, and in my opinion cannot, offer fractional shares. That makes direct ownership of even a tiny, unrepresentative index like the Dow Jones Industrial Average absurdly expensive: the purchase of a single share of each DJI constituent would cost $4257.52. A market-cap weighted purchase of the average would be many times more expensive, if you can dredge up from grade school how to calculate lowest-common-denominators.

Fee-free trading of fractional shares will make mutual funds obsolete

I’m making this claim in the strongest way possible not because I think it is anywhere close to happening, but because I think it is inevitable.

The earliest, easiest adoption will come in market-cap-weighted funds: when a Google or Excel spreadsheet can sit on top of your brokerage account and sell losers while replacing them with the shares of similar companies at no cost, why would anyone own a mutual fund or even an ETF that blends together the tax liability of capital appreciation with the tax benefit of price declines?

Active managers and funds will feel the pressure a bit later, but they’ll feel it eventually. Why pay an ongoing management fee when you can subscribe to a newsletter or website that sends a .csv file individualized for your brokerage and your tax lots?

Shareholder democracy matters and mutual funds aren’t helping

It’s a cliche that three companies (Blackrock, Vanguard, and Charles Schwab/TD Ameritrade) control a vast swathe of publicly traded shares through their mutual funds, and it’s fashionable to point out they cast their votes as shareholders in ways their investors may resent, or even despise. Vanguard has gone so far as to hold its shareholder meetings not in populous, accessible Philadelphia, but in a satellite office in Arizona, to make sure as few people as possible show up and complain about how it deploys its influence over global capitalism.

I don’t think that mutual fund companies vote their shares with any kind of corrupt intent; on the contrary, I believe they vote them based on their belief about what is going to produce the greatest financial return for the shareholders of their mutual funds.

But that’s not how people vote, and if in 20, 30, or 50 years direct indexing has allowed investors to reassert humane control over the companies they own, it will ultimately come to be viewed as an enormous economic and ethical revolution.

Become a Patron!