The fact that the largest market index funds hold a significant competitive advantage over smaller funds is undisputed. As fund management companies increases in size, the cost to manage their funds become a lesser percentage of the fund size, and their larger revenue streams allow funds to lower fees, which in turn makes them more attractive to investors. This sounds like it should be good for the market and investors, but maybe not.
In a recent paper published in the Boston University Law Review1, the authors examined three major index companies: Vanguard, BlackRock, and State Street Global Advisors. The authors found that over the last two decades a vast majority of money flowing into index funds were held by these three companies, and that their combined share of the S&P 500 went from 5.2% in 1998 to 20.5% in 2017. It was also noted that these funds generally vote on all of their shares, and that in 2018 represented roughly 25% of the shares voted in director elections at S&P companies. They projected that if the trend continues these three companies could dominate shareholder voting in many major U.S. companies in the next two decades.
If their projection is correct, many publicly traded companies could lose their corporate governance. This would have a profound impact on how those businesses are run and what their incentives are, and would impact the market as a whole, posing a threat to a healthy marketplace. And as more shares are held by passive index funds that blindly purchase based on a percentage of market share, fewer shares will be traded to create a true value for individual companies, creating over- and under-valuations.
Personally, I have been a fan of index funds, as they make it easy to diversify your investments with a single trade. However, I occasionally come across a paper or article that makes me question my past assumptions. If you would like to read the full paper you can find it here.