John Coates on *The Problem of Twelve: When a Few Financial Institutions Control Everything*

John Coates is a professor of law and economics and the deputy dean of the Harvard Law School. John is also the author of a new book titled, *The Problem of Twelve: When a Few Financial Institutions Control Everything,* and he joins Macro Musings to talk about it. David and John also discuss the basics and beginnings of index funds, how they may undermine capitalism, the issues with private equity, and a lot more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: John, welcome to the show.

John Coates: Thank you. Delighted to be here.

Beckworth: Well, it's great to have you on, and your book was a fascinating read. We'll provide a link to our listeners in the show notes so they can get a copy of the book, which is just now being released, when the show will be out, but it really helped me appreciate better some of the issues with the index fund industry, private equity, many of these things I really didn't appreciate until I read your book. As a macroeconomist, I occasionally veer into the financial regulatory policy space lane, but your book was very interesting, and I'm excited to get into it. Maybe tell us the brief executive summary of the book and the motivation for writing it. How did you get into this topic in the first place?

The Problem of Twelve: An Executive Summary

Coates: Yes, good question. I've been working on corporate governance in one way or the other, and corporate finance, for most of my career, longer than I care to remember sometimes. A few years back, Harvard Business School was revamping the basic intro readings they were giving out to all their MBAs, and they asked me and a colleague over there, Suraj Srinivasan, to do one on corporate governance. We did a kind of a basic primer on, like, "Here's how companies work and how the capital markets interact with them." Towards the end, they said, also, "What's changing? What's new?" I really spent some time thinking hard about how things had changed over my career from the late '80s through today, and of the things that were the biggest changes, it seemed pretty clear to me, stepping back, connecting to the title of your medium here, the big macro changes, not macro in the sense of deficit spending, but macro in the sense of large, systematic changes, they were the rise of index funds and the rise of private equity. The third piece was globalization. That sort of interacts a little bit with these, but it's really quite distinct.

Coates: Those three things, to me, really marked off corporate governance in the 2010 and forward era differently than the way the corporate governance world had functioned over the prior 30 years. That really was the origin of this book. I then kind of leaned heavily into the index fund space to just kind of map it out. I kind of knew they'd been rising. I am a longtime Vanguard investor, but I had not appreciated until I really got into the data just how significantly they had grown and also had not appreciated that the result of the model offered by index funds, which is, "We're not going to do anything complicated in terms of picking securities. We're just going to get a third party index, and we're going to buy all of those, so we can focus on keeping costs low," and they do. Their costs are dramatically lower than actively managed mutual funds, much less even more expensive ways to invest.

Coates: The result of that is they have pretty obvious and powerful economies of scale. There are fixed costs associated with setting up the machine to gather money, find the securities, buy and hold them, and then as necessary, offset redemptions and inflows to make sure that they're more or less every day making ends meet. That machine had a lot of fixed costs, and then after they get the machine built, I don't think economies of scale go forever, but they can go pretty far in terms of assets under management. Alright, so that means that with the rise of index as a way to invest, you also had a dramatic increase in concentration. In 1995, if you'd picked the top 25 funds of any kind, investing in the public capital markets, they would not have had as much stock as the big four index funds do today. And so the switch from active management to passive index management met a corresponding increase in economies of scale, concentration.

Coates: Now, concentration all by itself in a financial sense is fine, as long as you don't get down to the level of monopoly or monopoly power. I don't think anybody really thinks that any one index fund has true monopoly power in the index fund market because there's still three or four or five that are pretty fierce rivals and there’s pretty good competitive pressure there, but what it also brings, though, is concentration of control because when you buy equity, you get a vote. When you get a vote, marginal vote, kind of irrelevant, 25% of the votes, quite important, basically enough to literally control companies if they really wanted to. Now, they choose not to. There are also legal inhibitions that have been in place for a long time. So, they don't really reach out and tell companies how to make specific decisions most of the time, but they do have an enormous amount of influence. That's a genuinely new thing. It would not have been true 15 years ago. That's the first half of the book or the first half of the content.

Coates: I also, though, noticed that private equity was growing pretty dramatically, less noticed because private equity has, from its inception, been designed as a legal technique, like it's a legally designed industry. They've designed their institutions to avoid certain kinds of regulation and most prominently disclosure at the portfolio level. And so, it's a little hard sometimes to know exactly what they're doing or how big they've gotten, but they do have private trade groups that kind of gather data and publish it, Preqin, and PEI, and a few others. Ironically, actually, the advisory companies in private equity, have themselves become publicly traded companies, so they have to make reports. So, you can get some data about assets under management from their reports in the funds that they manage. You put all that together and you compare it to Fed data on the size of the corporate sector of the economy, and private equity has grown even faster than index funds. Most readers probably know a little bit from the newspapers, they buy whole companies, right? They don't buy 5%, 10% of any one listed company. They buy an entire company. They either take them private if they're an existing public company or they buy them from another private owner like a founder or a family or increasingly from another private equity firm. Then they run it for 5 to 10 years in the traditional model and they exit in some way.

Coates: Also, I should say, they do the acquisitions with a lot of debt. So, they're very active in the debt markets as well as in the equity investments that they make. They're more central to a lot of capital market activity as financiers. Index funds are quite important in bonds, too, but again, they're passive. They're just buying and holding. The PE funds use that money. They borrow, they buy, they reshape, they manage, they resell, et cetera. They've now gotten to be somewhere between 15% to 20% of our whole economy. And that, again, is a compound annual growth rate that's more or less the same as the index funds, both of them around 15% over the last 30 years, which is significantly greater, of course, than the economy and greater than the corporate sector of the economy. Both kinds of funds are increasingly taking over the governance of more and more of American business activity. That's the second part of the book. I have some views… the punchline of the views, and this is now getting a little bit less purely descriptive and more normative, that it's just not a sustainable equilibrium for 12 people. The 12 just comes from-- it's a small number. It's meant to capture the idea of 12 people that can sit around in a room and decide things if, in theory, they want to. There are also 12 disciples, I think that might have some kind of echo in the background in my mind.

Coates: Anyway, when you get 12 people who can either, in the case of index funds, really strongly influence the governance of every listed company, or in the case of private equity funds, totally run a third of the economy, [which] is where we're headed, that's not politically a stable place. We've been there before in American history. Every time we've gotten to that much financial power and financial concentration, there's been a political and legal response. We've already seen that emerging in the case of both kinds of funds. The book ends kind of in the middle, if you will, of the story, because we're living through where it's going to go. I have some views about some bad directions we could go and some better directions, but mainly, the book is intended to kind of get everybody up to the same playing field so that when we have this public policy debate, at least people are informed about what it is that we're debating. That's the book, that's longer than a quick soundbite, but-

Beckworth: No, it was great. It was great. This is an important issue. Like I mentioned before, it really informed and helped me better understand these issues because it has come up. We'll get back to some of the political issues, I believe, chapter 4 or 5 in your book, you get into that in more detail, but this is already an issue, as you mentioned. Republicans are upset from one side. Progressives are upset from the other side. We'll come to those issues, but the key tension that's in your book is this development where we have economies of scale, at least with the index funds, pretty clear economies of scale, lower costs, but those also imply growing concentration of power. You don't get one without the other because you've got to get big to get the cost down, but then you also get the power. It was interesting in your book, though, you also note that the cost savings aren't so clear for private equity, or for the total social good, at least, is not as clear, but nonetheless, they're very powerful, as you mentioned, buying up a third of the economy. Maybe just to kick things off, and again, we'll come back to more specifics later, but you start off with an example that's very illustrative of this issue. This is the 2021 proxy battle at ExxonMobil by a small fund called Engine No. 1, I believe. Walk us through that story and how it illustrates the issues at hand.

The 2021 ExxonMobil Proxy Battle and Its Implications

Coates: Yeah, so, in 2021, a tiny little private fund, a hedge fund, that no one had ever heard of, with basically seed capital from the founder, bought up a tiny amount of stock of Exxon's outstanding shares, and largely based on two themes, ran a proxy fight to try to change four of the Exxon board members. The two themes were, first, Exxon's performance had been lagging by at least a year. Relatedly, they were kind of an outlier among the major oil companies in continuing to do the most amount of quite expensive capital expenditures for more oil and gas development. That was one thing. You guys are losing money, and you're making big investments, and you're weird, and no one else is doing what you're doing. Then the second theme was, you're completely unprepared for the transition to a lower carbon economy. Not only are you unprepared for it, you're not sharing with your own investors what you're doing. You don't seem to have a strategy, et cetera.

Coates: It was kind of a green, climate-oriented attack. It wasn't really that they were saying they were going to make Exxon somehow become a solar company, but they were really saying, you're just not engaged in the strategic thinking that you're going to have to as the pressure from the political sphere grows to effectively raise the cost of oil and gas use and invest in and subsidize lower carbon forms of energy. You're going to get caught flat-footed. In particular, you're going to get caught flat-footed because you're the highest-cost producer right now. If you look at an array of major oil and gas producers, you've got Aramco sitting right at the source of oil, being the lowest-cost producer, and you've got Exxon at the opposite end, being really expensive in the way they extract. That was the proxy fight. Now, it's not an unreasonable set of themes for an activist to throw at Exxon, but I would say, if you'd taken a poll, even of reasonably informed people, they would have all given Engine No. 1, this little hedge fund, a tiny chance of getting anywhere because they own less than 1% of the stock.

Coates: Nobody had ever heard of them. They didn't have a track record. Really, some of the individuals had worked for other funds before, but still, they didn't really have a track record. And so, it just seems odd to imagine Exxon going green in any way, and yet, they won three board seats. And they won three board seats even though Exxon tried to preempt them by pulling on a couple of people that looked more interested in sustainability before the proxy fight occurred. It didn't stop the proxy fight, it kept going, and even though Exxon spent millions and millions of dollars trying to defeat it. Why did it win? Because of the index funds. Basically, index funds’ concentration makes it so that a hedge fund like this one, it doesn't really have to persuade hundreds of thousands of individual shareholders or even hundreds of different fund managers, as would have been true 20 years ago. Instead, they really only have got to persuade about 12 people, including the major index fund managers, and they did. They convinced BlackRock and Vanguard and State Street to vote for their three of the four-- they didn't vote for all four, they voted for three. They also got support from other kinds of institutional investors. It's not just the index funds, but they were outcome determinative. If they had gone the other way, it would have lost. Because they went the way they did, it won, they won three seats.

Coates: I think this sort of sent a shockwave, certainly through the corporate governance community. Not to toot my own horn, but I've been saying, this is coming, something like this is coming. So, for me, it was sort of a sense of validation. It certainly also sent off political shockwaves. I mean, again, you said we'll come back to it, but just a note here, for Exxon to be pushed in a green direction by index funds finally connected the dots in a way that meant that from there on, the Texas governor, the West Virginia governor, the Florida governor, Mike Pence, go down the line of Republican politicians, began seeing that there was a real connection between asset management and political outcomes. They had things to say about that, let's just say.

Beckworth: It's very interesting. I'll also throw out another name, Vivek Ramaswamy. He's now a presidential candidate in the GOP party. He started his own Strive Asset Management in response to developments like these, so very interesting. We'll come back [to it]. Let me just ask this question now, though. My impression is that most of the contention or controversy is with index funds. I don't hear as much with private equity, although it's a serious issue, as you outline in your book, but it seems to be a lot of the noise presently is around index funds. Is that a correct impression?

Coates:  Well, not really. Here's what I'd say, I do think that index funds and the idea of ESG, many of your listeners may have heard the phrase as a concept for how large companies should manage themselves, those have become very politically controversial on the presidential level, particularly among Republicans. Then there's fighting back and forth with Democrats over that issue. I do think that's gotten a higher level of attention, but private equity has episodically been just as important in our political cycle, and I think because they're growing and continuing to have even more and more influence over the economy, that's going to come back again very predictably in the next year or two. Just to remind everybody, Mitt Romney lost for lots of reasons, but one reason he lost was because his name was directly attached to private equity.

Coates: And people went out, journalists went out and did research on the deals that his firm, Bain, did while he was there and with varying degrees of fairness, depending on how you think about the newspaper investigations, blamed him for many of the side effects that predictably happen after a buyout. There's often layoffs, that's a thing that could be pointed to politically. There's sometimes bankruptcy. Sometimes there's financial distress. His simple association with that industry… would he have won without it? Maybe not. He was also sometimes not a great campaigner for other reasons, but it definitely had an influence on the voting outcomes.

Coates: And more generally, there have been bills pending for years and years, and every year they get a little bit more support, to variously take away some tax benefits that the private equity industry has been very carefully structured to keep, to more limit the way we treat debt as tax advantage relative to equity, which is crucial to the PE business model, and to lean into more supervision of the industry in direct ways in some cases, like just flat out limiting what they can do once they take over a company or softer versions of that. You're right that if you just read op-eds, currently, the index funds are probably slightly more prominent, but I think the reason that's true is also true of private equity. The reason index funds are controversial is because they matter, because they're really affecting outcomes. The same thing is going to be true of private equity over time. My book is not super micro about predicting the next law that's going to pass or the next election. It's really saying, "Look, this is a 30-plus-year trend. The forces behind both of these fund types’ growth are continuing. They're not going away. Therefore, we're going to keep having political fights over the effects they have."

Beckworth: Yeah, and as awareness grows of the extent of private equity’s reach, I think there'll be even more so. I'm old enough to remember Michael Milken and Drexel Burnham, which was a great story, and that was very much out there in public. What you're saying is, look forward to more stories like that. Alright, let's go back to index funds in chapter two. I want to just park there for a bit, and maybe just ask a very basic question. What is an index fund? How is it different than a mutual fund? What role does it play? Maybe also walk us through the interesting history of Vanguard and Jack Bogle.

The Basics of Index Funds and the History of Vanguard

Coates:  Sure. An index fund typically is structured as a mutual fund. There is just a subset of mutual funds. What's a mutual fund? It's a collective way to invest that's regulated pretty heavily in the US, dating back to 1940, when those laws were first put into place. The combination of the laws and some basic contract design is you turn over your money to an independent, reasonably well-restricted fiduciary, who then takes that money and invests in whatever, and they tell you what the whatever is. For most of the history of mutual funds, they would actively try to pick and choose some stocks rather than all of them. They paid professionals a lot of money to do that. That's still around, T. Rowe Price, some of the bigger, famous Fidelity funds, Magellan and the like, run that way, and they're still around, but come the '60s, some financial economists really start looking hard at the numbers and conclude that most stock picking is not worth the effort.

Coates: Bottom line, the market moves, at least in the short run, in pretty random ways, and if you track money managers over time, on average, they don't do any better than just randomly picking stocks. Certainly, once you add in their fees, the costs that they will charge you to try to outguess the market, they don't, on average, do better. Now some people still believe in a very strong version of this, I don't. I think there probably are money managers who can consistently do better than the market over time, but the challenge for a typical retail investor is not simply, is there alpha out there? Is there a way to beat the market? Can you find the person who can do that? It's not good enough to say, "Look at their 3-year, 5-year, 10-year lagged return," because there is so much noise in the markets that you could have, again, monkeys, doing better than the market over three years randomly choosing things. You wouldn't know the difference from the data. You can't really be sure that what you're seeing, even when somebody has outperformed, that it's not just luck, and that the luck's going to regress to the mean over the next three years.

Coates: Alright, so you put all of that together. That was financial economic theory. Jack Bogle, either directly or indirectly, consumed all of that. He was a manager at Wellington. He decided, "I'm going to go put this to the test. I'm going to go start a fund, start a complex, start an advisory firm, where all we're going to do is, in effect, try to achieve the market, not to beat it." As a result, as I said earlier, we can charge really low fees, so we're going to really compete just on, we're trustworthy, we're going to not steal your money, we're going to invest it the way we say we're going to invest it, and we're going to invest it at an incredibly low cost. That was the birth of Vanguard in 1975. It took at least five years for anyone on Wall Street to take them seriously. It made a very little dent in total assets under management for the first 10, 15 years, they were still well below 1%. Somewhere along the way, people began to start measuring, are they beating most active funds or not? Then net of fees, are they doing all in better? Lo and behold, the theory turned out to be right. They really were doing better than most active managers over an increasingly long period of time.

Coates: That story that I just told slowly started seeping out through journalists, through financial advisors, et cetera, and flash forward to two, three years ago, famously, LeBron James, with lots of money at his disposal, from his sports activities and his endorsements, asked Warren Buffett… I don't know how they got together, some interesting story there. Why were they in the same room? Anyway, LeBron James asked Warren Buffett for financial advice. Famously, Warren Buffett said, "Put it in index funds. Find the low-cost index funds and just put it in that. Invest every month, as cash flow comes into you." That's what LeBron James has done. Reportedly, this is not my investigative journalism, just doing secondhand stuff here, but now LeBron James's wealth has tripled in the time that he's been doing that. He's now in the billionaires club and one of the richest people in the country. We've gone from people don't believe it at all, to Warren Buffett giving that publicly as the best advice, even to someone with as much money. Obviously, LeBron James could hire real investment managers and pay them good salaries and get them to do a lot more, but he seems to be doing just fine with indexing. That's the index fund.

Beckworth: You note that the industry takes off after 2000. You alluded to this just a minute ago. I understand Vanguard really takes off after 2008, the financial crisis, but there's three big ones, right? Can you mention those and then maybe rank them in terms of importance?

Coates:  Vanguard was first, and I think they're second in terms of asset management today. BlackRock came along later, and they're the largest. They inherited, they bought through a series of M&A transactions, a business that was initially started by Barclays, which was exchange-traded funds. We don't really have the time to get into the details of how they differ from mutual funds, just take it, they're pretty similar to mutual funds, but they did index-based exchange-traded funds, so they're very similar in design structure and performance as what Vanguard offers.

Coates: They've been maybe a little more aggressive in their marketing and using institutional channels to roll their products out. They've grown a little faster than Vanguard. That's why they're number one. They've also grown globally in a way that Vanguard was a little slower to do. The third one is State Street. State Street is mostly a commercial bank/back office service provider. Most of their money is not in investment management, but they do have a line of products, also ETFs. They were actually the first ETF, they innovated the ETF. They still-- most famously SPDRs, people may have heard of those. They're basically, again, the same, and they're roughly half of Vanguard's size.

Coates: Those would be the big three. I would add in Fidelity these days as a big four because although Fidelity, for a long time, remain committed to active management and sort of often opposed Vanguard, they were paired in marketing battles. They've actually become… more of their money is now indexed than not because they were already pretty big. Their total assets under management in an index form is close to State Street. When you put those four together, that's the concentration. The 12 people would be the four people who run them, plus the four people who are the heads of their investment management arms, plus four people who are responsible for voting decisions, the 12 people more or less in those institutions are the 12 that I kind of have in mind when I titled the book that.

Beckworth: You note in the book that together they control about 20% of large corporate America, is that right?

Coates: Actually, 25 if you added Fidelity.

Beckworth: Okay, 25.

Coates: Yes, it's 20 if it's the big three, 25 if it's the big four. It's not every company exactly because some companies are not in the same indexes as others. There's also a slight wrinkle which is that even Vanguard has multiple funds, but they aggregate their votes really up to the whole complex of Vanguard across all of their funds. They typically vote in the same way across all of their funds. Some of their funds are specialty indexes that maybe, for example, they have socially responsible investing, a fund which will leave out certain kinds of syntax companies or whatever. It won't exactly add up to be as if you took their total assets management and divided by the market cap of all companies. It varies a little bit, but somewhere between 20-25 for the big four, and it's growing. I've been tracking it and every year it keeps inching up. Every year, another half a percent, another percent. As I say, on a compound annual growth rate, 15% over the last 30 years, pretty consistent too. Not a lot of ups and downs in that.

Beckworth: 25% is still a huge number. I mean, more than enough to have influence, inordinate influence on outcomes for these proxy battles, for board decisions. You just need a couple of important groups. That's a nice segue into some of the issues that you raise in this book, why this matters. First, you highlight that it's hard for competitors to get into this. There's this economies of scale, which means there's the first mover advantage. You got to really mass produce, so to speak. You really got to get down that lower part of the average cost curve, and they're there. It's hard for someone new to come in and compete with these… the big three, big four. All they have to do is just replicate the market. You highlight, it's well known that active managers, the bigger they get, the harder it gets because they become price makers, and it's hard to find alpha, that extra profit, but all these index funds have got to do is just match the market, keep costs down, and they can do that, but this raises these concerns, these influences that they have that may be problematic.

Beckworth: I want to start first with the conflict of interest. What if Vanguard or BlackRock owned competing firms? For example, Vanguard, I understand, is the largest shareholder of both Ford and GM. If you own a sizable portion of both of those, I mean, you could clearly see, you might have other motivations and profit maximization at each firm, and maybe there's some collusion, some desire that you get this part of the market, I get that part of the market. I know there's some evidence for this, and I know Vanguard did the study that kind of pushed back against this, but walk us through that issue. Is there reasonable evidence that this is a problem, and should we be worried about it?

Conflicts of Interest in Index Funds

Coates:  Let me just first say, the possibility that common ownership, so Vanguard commonly owning more than one company that are at least formally competitors in the product market, the possibility that that could produce anti-competitive economic effects is something that I note in the book. It's not really my main focus because I think there's a problem, even if there's not, but it is a fair question. There's been a lot of research by other financial economists and other legal scholars trying to figure out, is the problem already here, the kind of problem you're sketching? There's back and forth in the literature about that as there usually is and anything complicated relying on econometrics. My own reading of the literature is that there's a fair amount of smoke. I get there with just kind of common sense theory.

Coates: If one shareholder owned all of the stock of both GM and Ford, no one would doubt that there would be probable collusion at the product level. You really wouldn't want to count GM and Ford as independent anymore. You'd just treat them as part of one company and then you wouldn't… alright, no one would really argue with that. If you've got a trend line that's going from fully dispersed, not common ownership, to more and more common ownership, okay, somewhere along there, we're going to start really having the problem that you're identifying. Whether we're precisely there yet or not and which industries is, I think, a harder question. I would tend to think the biggest problem of that kind are where the product markets are already pretty concentrated, so, famously, airlines, while they perform miserably as companies, they often have very little competition for any one route. There's only a couple of airlines that compete over any one route. All it takes is a little bit of a nudge from their common owners and maybe they don't compete quite as hard where they do have only one competitor.

Coates: To me, that just seems pretty intuitive. Everyone, of course, knows that it's flat-out illegal for the two airlines to agree not to compete. They go to jail if they get caught doing that. No one's really quite saying that Vanguard is getting the two CEOs of the airlines into a room and they're writing down in a memo, "We shall not compete." That's not happening. That's fiction, but what probably is plausibly happening is the two airline CEOs know that when it comes time for their annual assessment at the annual meeting by their own shareholders, one of their shareholders, Vanguard, owns both of them pretty equally and might be more interested in sustained revenue growth rather than short-term revenue growth that might come from a price war. It's really more in the way of incentives and anticipation of evaluation of management that this common ownership problem may be showing up.

Coates: As I say, that's not really the focus of my book because I think even if you could convince me that right now we don't have that problem, I think we still have a political problem, which is just that there's just too much concentration of power. Let me say one word about that. 25%, that sounds big, but maybe not overwhelming because sometimes the big four do split among themselves on issues, so maybe it's really only 10% or 15% for any pair, but many shareholders don't vote. 20% typically don't even return the ballots. They don't even abstain. They don't even open the envelopes. They don't even know they own the stock. They inherited it and they don't realize it's in a trust that they've not paid attention to. Anyway, 20% don't vote. When you take 20% out of the denominator, 25 goes up fairly substantially. When you take into account that the typical votes are not 1,000 different dimensions, it's either on or off, you vote yes or no, you're already going to have, typically, some other shareholders voting in both directions. So now, the baseline over which that 25% or 30% or 35% will tip, they really do have outcome-determining power now, without even getting to 50%. I'll just note, that's my problem.

Beckworth: That's the big issue. Well, you note in your book that they have these networking events with "governistas" and other investment fund advisors. They come together, they're not supposed to collude. Maybe there is some collusion, but they're all in similar conferences. All of us go to conferences. We meet people in our profession. They're doing the same thing. They do that, one, and two, you note that they have engagements with the companies that they own in their portfolio. Let me read an excerpt from your book, page 47. It says, "BlackRock's 2019 governance report notes that from July 2018 to July 2019, it participated in over 2,000 engagements with nearly 1,500 companies, including multiple meetings with 375 companies. That level of engagement is a substantial increase from 2017 when BlackRock reported roughly 1,300 engagements." They're having lots of engagement and the engagements are growing. They engage, they're in similar networking events. This is the concern you have.

Coates: Yes. I mean, they're careful not to publicly be seen to do what they did in the Exxon fight too often. In fact, they haven't done it since. Engine No. 1, that hedge fund, has given up on the idea of the things it was doing at Exxon. It's not like that's being replicated every year in dozens of companies. They got a lot of blowback from that. So they're political animals and they're recognizing that there's a risk to too open a form of control. Frankly, there were laws already that got in the way of them directly telling companies what to do. Instead, they do this other thing. They engage, as they call it, which means they meet with management, and they offer their views.

Coates: Their views can be pretty benign stuff, like, "We notice that your customer retention metric that you report is much worse than your competitors. You really ought to look into that." Nothing wrong with that. That's a perfectly shareholder-oriented thing that any shareholder, if they're paying attention, would say, but it also could range to things that either raise the antitrust issues you were asking about earlier or could raise questions about public policy. This is where the political battles come up, or they could also, as you suggest, raise possible conflicts of interest. What if the engagement is really meant to benefit their 401(k) business, which is another part of the way they grow assets? They're going to convince this company to put their 401(k) work with them. I will note that in the Exxon case, Exxon had put its 401(k) business with not one of the big four. Would it have come out differently if they picked one of the big four? Maybe, I don't know, but in any event, that's all of those kinds of issues.

Coates: That's the soft way in which they're using this kind of influence. Again, if we were static, and you could freeze the world where we are today, maybe we could live with that. Maybe this is not so terrible, but the problem is the trend line is continuing, and all of the forces that have led the index funds to grow are going to keep growing. Economies of scale are going to get more important as they grow. It's going to get even harder for… pick your imagined future competitor. Goldman decides to get really heavily into index funds. It would take even Goldman a lot of investment to get to the scale that they're at. It's hard to gather assets in the investment business. It takes time, discipline, and continued investment. These guys are already positioned to just keep growing.

Beckworth: Let me raise one other issue that's been surrounding the index fund industry. I don't think it's your key issue, but it's one that's come up. That is, do index funds undermine capitalism, price discovery, and markets? There's this notion that if markets increasingly are indexed, at what point do prices stop moving around because there's discovery of a good firm, a poor firm? Even if the index doesn't take over the entire industry, they become the benchmark. Even actively managed funds will have to measure up and do what the index funds are doing. You get to this place where every asset price is correlated, or every investment strategy is correlated. The whole point of capitalism is creative destruction, discovering new ways of doing things. Prices are key to it. Is that a concern that still resonates with index funds, or is it something that we've moved on from?

Do Index Funds Undermine Capitalism?

Coates:  Well, they would say, the index fund providers would say, "Look, it's not our fault. You guys are coming to us and saying, please put our money in the following fixed indices,” and they just happen to be largely the same indices across the complexes and across investors. I do think there is some limiting case worry there. There is, of course, going to be typical market responses. As indexing grows, I don't think it's a coincidence, I can't prove causally that this is a relationship, but I believe it intuitively, hedge funds have also grown. Certain kinds of activist interventions by some investors have become more common, and more kinds of investors have become active, by which I mean they go in and they purposefully try to shake up management like at Exxon.

Coates: I think partly, the intuition is, if index funds are just buying every company and holding, which is what they do, then price pressure on the company directly kind of is static because there's no marginal buying and selling driven by performance. It's just driven by inflows or outflows to the index. That means that if there's a gap between fundamental valuation and market pricing, then it will grow. That will then provide an opportunity for other kinds of investors to come in. I think, again, it's intuitive that at some level, actively managed, regular old mutual funds will start earning their keep again. They'll be able to show, "Sure, Vanguard's great. It's only five basis points. You get the market, but we can beat the market. We'll charge you… okay, we'll charge you 15 basis points, but even net of that, we're going to do better for you consistently." We'll get there eventually. At that point, I think then capitalism will continue then to do what it's doing, which is allocate capital in a price-sensitive way. I don't really think in the long run, that's a deep challenge, unless, let me just… one little footnote, unless the reason money is going into indexes, and sometimes this is true, is because of kind of non-market forces.

Coates: For example, many employers increasingly set as the default, for your 401(k), an index fund. That's true at Harvard. I'm sure it's true at a lot of [your] listeners' employers. That's not really a market choice. I mean, it is a market choice. It's embedded in the labor market, but it's quite an opaque choice for many employees. The money goes into the 401(k), and they don't really pay attention to if it goes into an index fund. Maybe we could overshoot that equilibrium. If it's sort of institutional or informational problems that are pushing money towards indexes, it could go well past the point that actually it makes sense as a matter of capital efficiency.

Coates: We might end up there. We might end up at a place where there's just persistent under-overall performance because of how much is passively being invested. I tend to worry less about that. My bigger worry, the thing I think it'll hit sooner, is that the political worries about indexing will lead to bad legislative intervention that will destroy the industry. I like the industry. I think it's a great industry. For normal mom-and-pop investors, it's a really cheap and safe way to diversify and invest for the long run. I don't like some of the proposals that would effectively really curtail the business. I'd like to get to a place where we could address my political problems and then maybe your capitalism problems without destroying the ability of these funds to do what they do quite well.

Beckworth: Yes. Your answer, in short, is trust capitalism, trust markets. If we do go inordinately towards index, there'll be some opportunity to make money some other way, and markets will innovate. Let's move to private equity. I want to read the first paragraph from that chapter because it's very powerful. You say, "Private equity funds, such as Apollo, Blackstone, Carlyle, KKR, are doing as much, if not more, than index funds to erode the legitimacy and accountability of American capitalism, not by controlling public companies, but by taking them over entirely and removing them from the SEC disclosure regime. Private equity funds are creating their own problem of 12." All right, expand on that.

The Private Equity Problem

Coates:  Sure. As I alluded [to] earlier, private equity as a mechanism for ownership has been increasing its share of the economy at a 15% plus compound annual growth rate for 30 years. That's through ups and downs. Right now, they're probably facing some headwinds in their core buyout business from rising interest rates. I don't think buyouts are necessarily going to keep going up every single year, but they're moving into credit markets. They're adapting in ways that allow them to continue to grow through ups and down cycles in the macroeconomy. Okay, that's the first point. As I said earlier, currently 15%, 20% of the overall corporate sector, one in seven or eight of all workers in the US, whether they know it or not, work for a private equity firm. That's also continuing to go up. By design, they do not have to report anything to the public or even really to their own investors as a result of regulation. They're designed to not trigger SEC disclosure. They also lobbied very effectively in the '90s to get the laws changed in ways that make it easier for them to not trigger disclosure.

Coates: Now, you might think from the title, private equity, that it's just a bunch of billionaires investing money, we don't need to protect them, you don't need rules for that. If it were individual, really super rich people, I might not directly worry as much, but it's not. Mostly, most of their money is actually public money. It's money coming from public pension funds, from sovereign wealth funds, from endowments, from insurance companies that pool the capital of millions of Americans. It really is other people's money in that sense. The people that are supposed to be representing the ultimate owners of that capital in negotiating with the private equity firms over what they disclose, let us just say, I worry about their capacities and their incentives.

Coates: They, after all, many of them bought CLOs and got wiped out in 2008. They're sometimes politically appointed. A lot of pension funds for public government employee bases are very heavily inflected politically. A fair amount of corruption occurs in that part of the asset management business from time to time. I am not nearly as confident about whether the capital markets are exerting good pressure on private equity as some of my other academic friends. They tend to think, "Oh, big guys, let them negotiate. We don't need regulation. We don't need public disclosure." I don't have a compelling case to prove that the negotiations are terrible other than every single time I get brought into interactions in that business, I notice pretty amazing gaps in how they negotiate how their money is being managed. Let's just put it that way.

Coates: Alright, more importantly, because the industry is designed not to disclose anything, no one really knows. They don't even know necessarily. They obviously have better information than we do, but they only know more or less what they do for themselves. On something as simple as, is the risk-return good for private equity, we don't know. Steven Kaplan at Chicago, who's probably, I think, the leading student of this industry for decades, has at different times said different things, I'll say first, and currently sort of seems to be, "Well, they basically can do as well as the market." Now, what's interesting about that is, obviously the investors in private equity funds, they see the returns. I mean, they get checks or not, eventually, but what they can't do easily is measure the risk of how their money is being used because they really don't get full disclosures about the portfolio investments that the funds make. They certainly don't then report that out in any way that anyone else, like an academic or a journalist or the public, could assess.

Coates: The best you can do even on pure investment returns is just kind of guess from industry data, more or less roughly what the risk is, and then relate that to what's publicly reported about returns, or a few limited partners of these funds that do turn over their data through a third party provider, sanitized of detailed information, and using all of that more or less, it kind of looks like they're matching public market returns. That's not so great. If you're only just matching public investment, it's not clear why you're paying giant fees to these people. Again, go back to the index fund argument. You're paying 2 and 20, by the way, 2% of assets under management and 20% of returns. That's a lot of fees over a giant industry. That's just on investment. Then you've got the social side, and this is where it gets more political.

Coates: It's a lot harder for the public to feel confident that the way this money is being used in business is ultimately good for society if there's no disclosure, if the only disclosure happens when there's a bankruptcy, which there is frequently in the private equity industry. You get some information, but typically of the worst kind. It's like at the worst moment for the industry, "That's what we're going to focus in on, Toys R Us or Neiman Marcus," or whatever. I think personally, this would be my pitch to the industry, you would be better off politically, and frankly, it'd also probably help you as a business matter, if there were some disclosure that you made about your portfolio companies.

Coates: Nothing like full on public disclosure of a public company, like a listed stock, but annual, some minimal disclosure about which industries you're in, some information about risks attached to it. I think in the end, if they insist on remaining totally dark, you're going to have a moment where we have a predictable downturn in the economy. You're going to have a spate of private equity bankruptcies because they run a high debt, high-risk business model. You're going to have a lot of people saying, "Everyone in my community got wiped out because of private equity." And then again, as with index, you're going to have the risk of a political backlash. That's worse than if they just get a little bit more responsible and embrace something now. I will note finally, no other country in the world links disclosure solely to whether you're listed on a stock exchange. In Europe and in Asia and in South America, if you're above a certain size, if the amount of assets a business has or its revenues or its employees is big enough, you ought to tell the world a little bit about who you are and what you're doing so that we don't worry about it too much. That's the basic pitch of that chapter.

Beckworth: Well, that's interesting. I didn't realize other countries do it differently in terms of size, not just listings on the stock exchange. One last point on this before we move on, you made the case pretty eloquently in the book that it's maybe best case scenario [that] they match the market, but that rests on tax arbitrage, right? I mean, the whole point of this industry or a big part of this industry is that they can finance cheaper because of debt. They're leveraged buyouts. As you, I think, mentioned earlier, there are some proposals to make that less of an opportunity for them to do that. Are they really earning anything more than the market if you adjust for the fact that they get this tax advantage? It's not clear.

Coates:  I completely agree. I'll also add that they have another tax advantage, which is the taxation of the returns to the equity principals in the form of carried interest. It's basically taxed like capital gains as opposed to income, even when really what they're doing is compensating their professional staff for their time and effort, which in most employment situations would be taxed at normal income tax rates. They have two kinds of tax subsidies. That last one almost got killed a couple of years ago, but it was saved by Senator Sinema from out west who may not get reelected. That's another example of how they're right on the edge of some significant political change against them. Again, I think from their own perspective, they would be better off. I will say, they already put out reports, which they don't have to do, to the public. They don't have to as a matter of law. They already kind of recognize what I'm saying. I'm just saying it's worse than you guys think. Get farther out [on] that cruve-

Beckworth: Do more.

Coates: … of public relations management. Exactly.

Beckworth: Just to put a number on this, how much do they control of corporate America?

Coates:  Yes, so currently, it's 15-20%. It can't be too precise because again, they don't disclose anything about their portfolios, but if you take what they say publicly about their buyout funds, assets, and then take Fed numbers on total corporate sector, it's about 15-20% of that. Again, that's been growing pretty steadily over the last 30 years.

Beckworth: Okay, we are running low on time. We're not going to be able to spend as much time as I wanted on chapter four, the politics and political risk of the problem of the 12. We've kind of alluded to them. I will mention just real briefly here, a Bloomberg article that kind of gives the flavor of recent developments of what you cover in that chapter, but this article came out in July of this year, and it's titled, *House Republicans Probe BlackRock, Vanguard on Their ESG Policies.* Just briefly here, a few excerpts, "House Judiciary Chairman Jim Jordan and two other House Republicans fired off letters to financial industry giants, including BlackRock, Vanguard, and State Street, contending their efforts to combat climate change could violate US antitrust law." And there was a number of efforts, like you already mentioned some of the state governments that are Republican have pushed back against some of these moves.

Beckworth: Ron DeSantis has made a big deal about this in his campaign. On the left, as we alluded to earlier, they're also pushing because they don't think these firms have done enough, they haven't gone far enough. And a recent development, John, I would like to hear your interpretation of it, so here's an article just from this July as well, this is from Financial Times, and it mentions, *BlackRock Offers a Vote to Retail Investors in its Biggest ETF,* and it notes that Vanguard has done that as well. So, now they're opening this up. Are they doing this in response to all of this blowback they're getting? Or what's the motivation behind letting retail investors have a vote? Second, does it address some of your concerns?

Giving Retail Investors a Vote?

Coates: So, absolutely a response, yes, to exactly what the book describes. Last summer, the 20-some Republicans in the Senate proposed effectively to take away their votes. It didn't go anywhere, but once a bill gets that many people backing it in Washington, sometimes they can take a life of their own. I think the industry as a whole said, "Okay, we got to do something," more serious than they had been. Now, to be clear, they're not proposing in the US, actually, to pass through votes. It sort of reads that way, but not really. What they're proposing is to let their own investors, pro rata, based on how much they've got invested, pick a policy, which is a kind of general statement, kind of more or less how to vote. Then the index fund would take that into account when it comes to their voting.

Coates: Now, these policies are limited in number. They're put out by other firms, principally. Ironically, they're put out by firms that are often considered even more politicized than the index funds, ISS, Glass Lewis. Then if you look at their policies, which then the index funds are sort of pointing to, they're often overtly political. One of them is written, for example, ISS, by the US Catholic bishops, who have articulated a Catholic way to invest in the economy. Then ISS has kind of taken those principles and then built them into a voting policy and then written it down so that a lot of the endowments for churches and the like have picked that when they do their own direct investing.

Coates: Now, BlackRock is saying, "If you want, if you're an index fund investor through us, you can tell us you'd like us to follow that Catholic ISS policy." Alright, now, a couple of points about this. It's not been implemented yet. it's not actually clear how they're going to implement it. For example, the policies are pretty general in a lot of ways, like for mergers, which shareholders have to vote on and Vanguard says it votes against a lot of the time, none of the policies say anything other than case by case, like, "We'll evaluate the merger based on the facts and circumstances, here's some factors."

Coates: If you tell your own shareholders, "You can pick a policy," all they're going to be telling you is, "It's on a case-by-case basis, think about the vote," which is already what they're doing. So, on a lot of the votes, this policy pass-through is not really going to change much. On some things, it will. There are some things where the policies are pretty clear, but now the next question is, how many retail investors are actually going to use this? If I had to bet, no more than 20% will. That's still going to be 20% of 25%, so that's 4% or 5% of the total votes that might get affected by this pass-through. Final point is they're going to have to prove to the world that they're doing what they say they're doing, and there's a lot of complexity under the hood of that kind of mechanism. I've been really down in the weeds with some institutions about how they manage… even brokerage firms, where you're really directly investing through them.

Coates: Merrill Lynch, they invest, proving that they vote the way you want them to vote, that's already hard enough. Now we're talking about an index fund, going to often a 401(k) plan, in theory, maybe go to the employees. You have multiple layers. I think people don't quite yet appreciate how complicated and potentially expensive this is. At the end of the day, I don't want them to spend billions and billions of dollars to do something that ultimately doesn't change much, that would be bad. I think we're going to continue to see how they tinker with this over time. I do think it is a direct effort to blunt the political criticism. It'll probably help on the margin, but if they keep growing assets, I worry that that's not going to be enough. I think eventually, we're going to get some type of cap, like no one fund can have more than 10%. I'd still give them 40 in total, but--

Beckworth: Let's end on that. That's your chapter five, what can be done. You actually say, "Look, simple solutions, caps, bans, more complicated laws, they aren't going to really do what's needed." And then you mentioned earlier, you appreciate what index funds have done. So, to quote you here, "It's not a problem to be solved, but a dilemma to be managed." What are your suggestions?

John’s Proposed Solutions

Coates:  I think the kind of thing they're experimenting with is the right kind of thing. All of the qualifications I just sketched are just my way of saying this is a work in progress. It's going to take multiple iterations. There's going to be continued controversy about how they're doing it, but I think it's basically the right idea. The right idea is this: Vanguard, let's say, represents 10% of all the money invested in the capital markets. The 10% in turn represents 50 million people. Among the 50 million people, most of them, most of the time, really don't have a view about what the companies that they're invested in should be doing. Fine, so let Vanguard vote how they want as responsible stewards. But sometimes, among the 50 million people, they really do care a lot about particular issues, and they have sharply different views. See our political system.

Coates: In those moments, Vanguard… it's not an ironclad law of nature that they have to vote exactly the same way and vote in a way that maybe doesn't represent anybody's particular choice. They could split the vote, they could vote for 10 million people this way, for 10 million people that way, for 30 million in the middle, they do some split. I think that actually is kind of a natural, correct way to reflect the very strong political preferences that American investors have, while preserving the index funds' ability to keep doing what they do very effectively. So, more disclosure, cost-effective disclosure, more consultations of the kind these policies represent, more recognition that certain kinds of issues are going to trigger individual preferences more than others, and be neutral about that. I think that's okay. I think that's better than doing nothing. I think it's better than squashing the industry.

Beckworth: Well, with that, our time is up. Our guest today has been John Coates, his book is titled The Problem of Twelve: When a Few Financial Institutions Control Everything. Be sure to get your copy. John, thank you for coming on the program.

Coates: Delighted to be here.

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