In 2017, index investing giants BlackRock and Vanguard each brought in about a billion dollars of new money per day. This astonishing rate of asset accumulation demonstrates the rising influence of passive investing. These two organizations, now the largest money managers in the world, are leading a revolution in how investors monitor listed companies.
Meeting index investors' information needs requires changes in financial reporting. Passive investors, who now control and vote 30% of all U.S. shares, care more about long-term governance practices than short-term financial metrics. These investors don't trade shares when accounting balances fluctuate. Accounting topics like revenue recognition, lease accounting, and credit impairment matter little to owners like these with a long-term view.
Listed companies that want to develop deep relationships with this group of owners must move away from an investor relations model in which CFOs offer analysts revenue or earnings guidance to a model based on independent directors discussing board refreshment, sustainability, and compensation with stewardship officers. Companies will have to modify their reporting practices if they want to meet the needs of these increasingly important investors. This new approach is another step in the long evolution of financial reporting that first emerged in the wake of the U.S. Civil War. Let's take a look at how we got to this new environment.
History of Financial Accounting
With the Civil War over, the United States was growing, expanding west into vast territories. Railroad companies needed enormous amounts of capital to lay straight, level tracks across North American rivers, valleys, forests, plains, and mountains. Wealthy British investors were willing to fund this expansion if they felt comfortable that they would get their money back. The disclosure of financial reports helped provide that comfort.
Over the next half-century, agreed-upon ways to communicate financial position and results emerged among executives, investors, auditors, and government officials. In 1934, Benjamin Graham and David Dodd published Security Analysis to explain how investors could use these reports to make money. The analysis of corporate financial statements permitted comparison between a security's market price and its "intrinsic" value. Astute investors could get rich if they bought stocks trading below intrinsic values and sold when the stocks became overvalued.
Four years later, economist John Burr Williams's The Theory of Investment Value introduced the technique of discounting future cash flows to calculate intrinsic value. All modern finance textbooks cite this method when discussing asset valuation.
In the early 1970s, Robert Trueblood, chairman of Touche Ross, chaired a committee (the Trueblood Committee) to explore the objectives of financial statements. The resulting report extended Williams's work and argued that accounting reports should be designed to allow investors to predict the amount, timing, and certainty of a company's future cash flows. This idea became the central idea in the Financial Accounting Standards Board's (FASB) Conceptual Framework, the foundation for U.S. financial accounting rules.
Also around this time, a group of economists studied the relationships between stock prices and accounting balances. Statistical analyses showed that security prices adjust quickly to earnings releases. Eugene Fama argued that it's very difficult for investors to beat the market with financial analyses of accounting reports. This reasoning became known as the Efficient Markets Hypothesis (EMH).
While no one believes that financial markets are perfectly efficient, experienced investors agree that they are competitive. Not even Warren Buffett beats the market every year. In 1976, John Bogle, reflecting on implications of the EMH, sold shares in the world's first index fund with a portfolio designed to match the returns of a stock market index.
Influence of Index Investing
Today, the vast majority of assets held by U.S.-registered investment companies are in mutual funds and exchange-traded funds (ETFs). Both investment vehicles pool investor funds to buy portfolios of securities. Mutual funds sell fund shares directly to investors, and fund managers stand ready to buy back shares at prices calculated after the close of each trading day. Shares in ETFs are sold through brokers and traded on security exchanges at prevailing market prices. A mutual fund and an ETF holding the same basket of securities deliver similar returns.
Some mutual funds and most ETFs hold portfolios of securities designed to mimic the financial return of a market index (such as the S&P 500 or Russell 2000) or a particular sector (like healthcare or oil and gas). Assuming that the median investor earns the same as the market returns, passive investing should outperform half of all active money managers within a market or sector. After considering the low operating expense, since it doesn't cost much to buy and hold a basket of securities, passive portfolios produce above-average net returns.
The benefits of index investing have attracted widespread interest in recent years. According to Moody's, about 30% of all money invested in U.S. mutual funds and ETFs is passively managed (http://bit.ly/ 2sr4QLa). The two largest money...