Index funds could face future ownership limits: Bogle
Among the risks posed to index-tracking funds are the potential adjustment to regulations surrounding their holdings, Vanguard founder Jack Bogle has said. Current rules specify funds cannot own more than 10% of a company's voting shares. The likes of Vanguard, BlackRock and State Street Global Advisors, all of which have substantial indexed assets, have swerved this requirement in the past by launching new funds. With the continued growth of passive funds, it's possible regulators either look to increase the 10% limit or potentially apply the limit to an entire fund family, Bogle noted. 

Has Vanguard, the asset-managing giant that has dominated its competition as investors trend toward the kind of low-fee and passive products it specializes in, become too big for its own good? A perhaps-unexpected expert says it is nearing that point: Jack Bogle, Vanguard’s founder, who is often considered the father of passive investing.

“The economies of scale just can’t keep going on much longer,” Bogle said during an interview with Christine Benz, Morningstar’s director of personal finance. Bogle suggested that if Vanguard hit $4.7 trillion in assets, that might be too large. It currently manages $4.08 trillion. Bogle retired as Vanguard’s chief executive officer, and he noted he doesn’t advise the firm’s management team.

“I don’t decide anything, I don’t have to take the consequences—but I do think that when you get down to these kinds of issues, one of the things I would say was, let’s take the foot off the accelerator and ease it gently over to the brake,” said the 88-year-old investment luminary, in the interview that was published last week.

Bogle said any scaling back of the investment behemoth, if it were to even happen, wouldn’t happen soon and would be fraught with challenges. “That’s a hard thing to do. We all know it’s going to have to be done sometime. I mean, maybe 25 years from now,” he said (Check out the full interview below).

Vanguard has been massively successful, with the assets it manages ballooning in recent years, as investors increasingly move into both passive funds and low-cost funds. Passive funds track the performance of an underlying index like the S&P 500 SPX, +0.27% , as opposed to actively managed funds, which look to outperform the index by picking stocks.

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Thus far this year, Vanguard has seen a staggering $276.2 billion in inflows, by far the most of any asset manager, and as much as its closest eight competitors combined, according to data from Morningstar Direct.

In second place is iShares, the suite of exchange-traded funds sponsored by BlackRock BLK, -0.15% , which has had $156.5 billion in inflows. Flows drop off dramatically from there. Dimensional Fund Advisors, the firm with the third-highest flows, had a comparably paltry $24.3 billion flow into its funds in 2017, or nearly 9% of Vanguard’s haul.

Over the past month, nearly $28.1 billion have gone into Vanguard’s passive funds; only $2.8 billion have flowed into its passive offerings. Even that demonstrates Vanguard’s dominance, however, as actively managed funds as a category saw broad net outflows over the month. Only Pimco, which focuses on fixed income, an asset class where active management is seen as delivering more value than stocks, had higher active inflows, at $3.2 billion.

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Data have repeatedly shown that passive funds outperform a vast majority of actively managed products over times. This is a cornerstone belief of Vanguard’s business model, which emphasizes passive investments. Another one has been rock-bottom fees. The average expense ratio, a measure of how much the fund charges customers to cover operating costs, for a Vanguard fund was 0.12% in 2016, according to the company’s own data, compared with an industry average of 0.62%.

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However, Bogle suggested there wasn’t much room for fees to go any lower. “We’ve only got 12 basis points to go, and let me say it: There’s an irreducible minimum, no matter how big you are.” He said it costs “a lot of money to run this business,” and said that if the average fee was eight basis points (or 0.08%, amounting to $8 for every $10,000 invested), that might not be tenable. “I just don’t think it’s worthwhile, hyping and trying to bring in more and more money,” he said.

Another factor Bogle said could be on the horizon, as pertaining to Vanguard’s size and popularity, involved the regulatory environment. He noted that the Investment Company Act of 1940 essentially prohibits a mutual fund from owning more than 10% of the voting shares of any security.

“If you had an index fund that owned 10% of the company, they’d have to stop buying it,” he said. “They couldn’t own any more.” He suggested that if such a case were to occur now, the manager could simply create another index fund to bypass this issue. Such a workaround is “totally legal right now,” he said, though this could be changed, speculating that the limit could be raised above 10%, or that it could even apply to “all the holdings of a given management company or fund sponsor,” which he said would be “a limiting factor.”

According to data from ETFGI, a research firm, Vanguard holds 18.7% of the ETF industry’s market share, with some $835.8 billion in ETF assets. That puts it behind iShares, which has $1.66 trillion in ETF assets, and 37.2% of the market share, but above State Street, which sponsors the SPDR suite of ETFs. SPDR funds have 13.6% of the market, and $607.7 billion in assets, nearly half of which are in the SPDR S&P 500 ETF Trust SPY, +0.21% , which has more than $250 billion as the largest ETF on the market.

Courtesy ETFGI

The popularity of both ETFs and passive instruments—each of the “big three” ETF providers focuses on index funds—has created a three-firm oligopoly, Bogle said.

“Oligopolies are not attractive to U.S. governments or world governments,” he said, adding that “this phenomenon for exchange-traded funds, and index funds generally, is all over the world.” It is at its strongest in the U.S., “but it exists almost everywhere, and I don’t see how it’s going to back down.”