CEO Weekly Worry ListCEO Weekly Worry List

Siren Song of Index Funds Lures More Investors

BlackRock – Issuers’ New #1 Investor

It is highly likely that BlackRock is one of the largest, if not the largest, institutional investor in your company’s stock. While BlackRock did not invent passive investments (that distinction goes to John Bogle of Vanguard), it is now the biggest passive investor in the market, with $3.4 trillion of assets in index funds and exchange-traded funds (ETFs). Add another $1 trillion in actively-managed funds and $1 trillion in other funds, and voilá, BlackRock is a $5.4 trillion global investment behemoth.

And these numbers keep getting bigger, with purported billions of dollars flowing into passive funds every week. Indeed, for the first quarter of 2017, ETFs experienced $135 billion of inflows – a truly enormous number. For perspective, the 1Q17 inflows were four times more than in the same period for 2016. If the rate of inflows continues for the full year, total inflows could reach $540 billion, handily eclipsing last year’s record of $287.5 billion!

“Closet Indexing” becoming a real phenomenon

As we suspected, the practice of “closet indexing” is worse than we thought. A study published in the Journal of Financial Economics examined the active-versus-passive management question on a global scale. The study found that as much as 20% of the world’s mutual funds are categorized as “active,” but in reality, generate results comparable to passive funds. In closet indexing, a portfolio manager achieves similar returns to an index by holding stocks in similar weighting to the index. Thus, the manager achieves market returns. Investors, however, are stuck with paying the higher fees associated with actively-managed funds, compared with the lower fees they could pay with passive investment vehicles that are billed as such. In Europe, financial industry groups have now published reports to “name and shame” these funds – including some of the biggest investment houses like Rothschild.

Non-GAAP proving to be a better indicator than GAAP

Read Professor Baruch Lev’s new book, The End of Accounting, for a provocative take on non-GAAP measures. Backed by extensive empirical evidence, Lev found that non-GAAP earnings are correlated to changes in stock price post earnings announcements, but GAAP earnings are not. He posits that investors essentially ignore GAAP earnings and that the new SEC framework to lead with these measures are a big mistake.

He argues that the share of corporate market value attributable to financial indicators such as sales, gross margin, assets and liabilities has consistently declined since the mid-1980s, while changes in accounting and financial reporting rules have simultaneously increased reporting complexity, introduced more management subjectivity, and added greater ambiguity to GAAP-based earnings to make them “deeply flawed measures of enterprise change.”

Other than adopt non-GAAP reporting, which has several drawbacks, Lev calls for Investor Relations Officers and their companies to provide alternative and more relevant information to investors to keep them engaged by illustrating the real value-creation activities the company is doing. He calls it a Resources & Consequences Report, which highlights non-accounting information that focuses on the company’s execution of its business model. Think churn rates, renewal rates, proven oil and gas reserves, new customers, new landing rights, and other measures of progress. As evidence, Lev looked at analyst questions on conference calls. Except for situations of unusually poor performance, analysts clearly focused on issues that affect a company’s strategic assets.