Could Low Cost Index Funds Have Saved Our Cities?

Feb 26, 2016.

No, but that doesn’t mean they aren’t safe ways for people, and maybe even collective entities, to invest a tiny bit of money for a tiny return. But no, as virtuous as they are, they are not a full solvency package for municipal finance.

At the What Wall Street Costs America project, PBI is attempting to narrate and provide learning resources on the damage done by high interest, runaway and hidden fees, and gambling losses for municipalities and states who’ve relied on Wall Street to manage and invest public funds. The very idea that we need to be having this conversation, of course, is disturbing. A few decades ago, finance capitalists got the notion that cities and states kept boatloads of money in savings, and needed more money because of declining property taxes and, eventually, declining tax revenues across the board, including as a source of federal grants to cities and states. Taking advantage of deregulation and the revolving door between financial and public sector personnel, Wall Street convinced local governments to marry their fortunes with firms. The results were felt in Detroit, Chicago, Baltimore, New Jersey, California, and Ferguson, Missouri. That’s what Wall Street has cost America.

Of course, PBI believes public banks are a solution to this–no high interest, no huge fees, a safe way to save and invest money, and acquire credit. But are public banks the only solution? A friend asked me why municipalities didn’t just invest their money in low cost index funds. Fans of the funds say they are a sound investment for the average person. LCIFs are extremely diversified, with a simple low fee and tax. They do well because they are low-risk and low-yield. Warren Buffet recommends them and even reportedly advised Cleveland Cavaliers star LeBron James to invest in them.

The key to LCIFs’ fan base is the distinction between active and passive investing, with the former being too complicated and “the talent too scarce” to get the kind of advice necessary for it to pay off without spending a hell of a lot of money doing so. Fans of passive investing see a conspiracy among investment advisers to steer clients away from LCIFs, or at least not over-publicize their success. One writes:

With the evidence overwhelmingly in favor of passive investing for the long-term, why won’t more advisors admit these facts and shift their focus to advising clients on the benefits of index investing rather than making believe they’re market gurus or trying to pick those who are? One reason – there’s a lot more money to be made by keeping the lie alive. The fees and commissions earned through active investing are considerably higher than what should be earned by telling the truth about passive investing and charging a fair fee for this advice. Even those advisors who have switched can’t bring it upon themselves to lower their own fee.

So that’s the arguments in their favor–they are low-risk and have modest payoffs and experts don’t want you to know about them. Fair enough. But how should we fans of economic democracy view them? Well, to begin with, the proliferation of LCIFs leads to weakened corporate governance. Currently, Apple’s “top three institutional investors are prominent index fund managers Vanguard, State Street, and BlackRock. Combined, these three institutional owners control 12% of its shares and, naturally, 12% of its proxy votes. That’s a lot of power to put in so few hands.” Although the article’s author, Jordan Wathen, doesn’t say explicitly what undesirable impacts could emerge, I assume they include socially irresponsible investment and business mismanagement. This may or may not affect returns, but it at least leaves a bad taste in one’s mouth.

More serious is the possibility that you get what you pay for: “[T]he reality is that returns vary over time and in some years certain active managers beat their benchmark and in some years they do not,” according to financial planner Nicholas Pontilena in a 2014 interview with a financial advice column.

This variance is probably going to scale accordingly. Low-cost index funds are safe and the fees are low (and goodness knows the fees are too high with other investments), but there’s no reason to think they can provide governments with the kind of funding they need in a world without reasonable taxes–at least, not in a world of engaged city government, and states would appear no better off than cities in that regard. To date (and I’ve looked extensively, but readers should help me out), I’ve found no evidence that they form any municipality’s investment profile.

And all the advice I’ve found indicates LCIFs are appropriate for individual investors and have a minimal positive return over long periods of time. That may indeed be a responsible form of long-term investment. Of course, public financial institutions can serve as backstops and supplements to private funds, so this isn’t a competitive debate. If anything, it raises the question of what city officials and consultants were thinking in the first place when they signed off on rate swaps or even put all their eggs in municipal bonds baskets. Many of them were on the direct or indirect take from the financial sector. Others wished they were. Still others just didn’t see the horizon of possibilities before them.

Any blueprint for providing sustainable and “fiscally conservative” municipal finance that bypasses Wall Street excess will most certainly involve a combination of public banks and modest, conservative investments. In the meantime, let’s keep working on building sustainable financial infrastructure that doesn’t rely on the good graces of shareholders ever. 

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