Twenty years ago, a young investor named Bill Ackman made an astute observation about indexation to investing legend Charlie Munger.

“We’ve heard a lot of discussion about how institutions and individuals use index funds,” Ackman, then 30, said to Munger at The Buffett Essays Symposium, a conference that took place in October 1996. “But to the extent that more and more capital becomes indexed — and if you think about index fund managers as really being a computer, then in terms of the voting of shares for instance — the more stock that is held by people who don’t care about individual corporations, the more there is a significant societal detriment to have capital in the hands of people who are just seeking average performance.”

The rise of indexing and the exodus into passively-managed index funds from actively-managed fund has gotten increasing amounts of attention in recent months. Among the concerns is that fewer investors are scrutinizing the corporate executives.

Ackman continued: “The result is that the more capital that is indexed, the more it inflates the prices of companies in the S&P and leads to poor capital allocation and maybe detrimental owner performance over time because some companies get more capital than they deserve.”

“You are plainly right,” Munger responded, “If you pushed indexation to the very logical extreme you would get preposterous results.”

The coming boom in indexing

“Empirically, the position of equity capital assets that are indexed is less than thirty percent of the total,” Lynn Stout, a professor of corporate and business law at Cornell Law School, pointed out at the time.

“That’s what is officially indexed,” Ackman responded. “There is an enormous about of capital that is unofficially indexed.”

“It’s called closet indexation: You keep the fee but you deliver the index.” Munger agreed.

However you measure it, most folks would agree that indexing is huge today, whether it be through index mutual funds, index exchange-traded funds (ETFs), or other strategies that aim to mirror the performance of a major benchmark like the S&P 500 (^GSPC).

Today, Ackman, 50, runs Pershing Square Capital Management, a $12 billion hedge fund that that takes large positions in a handful of companies and pushes for changes from management.

In 2015, Pershing Square suffered its worst year in its history, falling 20.5%. In his annual letter, Ackman dedicated a lengthy section to the impact of index funds on US markets that was similar to what he had said in 1996.

“Index funds and other passive managers have gained increasing market share in recent years,” Ackman wrote. “Investing capital in funds and ETFs that track major market indexes has recently been what one might call a ‘one way bet, and there is good reason for this. Index funds and ETFs have very low fees and have outperformed the average active manager in recent years. Last year, index funds were allocated nearly 20% of every dollar invested in the market. That is up from 10% fifteen years ago.”

Ackman noted that the top holders of America’s largest companies are often identified as one of three major index fund managers: Vanguard, Blackrock, and State Street.

It pays to be a closet indexer

The success of index funds and their use as benchmarks has resulted in more active fund managers charging high active-like fees while delivering average passive-like performance. These are the “closet indexed,” or as Munger put it in 1996, “You keep the fee but you deliver the index.”

“This is true because the risk of an active manager losing clients is typically directly correlated with its portfolio’s variance from the benchmark’s performance. Clients rarely fire a manager for modest performance below the benchmark for any one year, but client engagements and mutual fund flows are often lost if the variance is dramatic in any one year. This encourages managers to invest their portfolios in order to limit their variance to the S&P, with only slight over-and underweightings to sectors or stocks they believe will outperform. By hugging the index, their performance closely tracks the index, with underperformance attributable to higher fees and easier to explain away as ‘We are taking less risk than the index in the companies we choose to own.”

Indexation creates a problem for corporate governance, according to Ackman. As index ownership increases so does the voting power of index fund managers. The problem is that index fund managers don’t have the incentive to do the “incredibly burdensome and almost impossible job” of engaging in shareholder activism. Instead, index funds are incentivized to grow their assets to make money from the fees and support the incumbent managements.

Ackman’s worry is that if this trend continues the impact on corporate America could look a lot like Japan’s system of cross corporate ownership, which has resulted in underperformance.

The characteristics of a bubble are forming

“We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds’ constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on. While we would not yet describe the current phenomenon as an index fund bubble, it shares similar characteristics with other market bubbles.

The symposium was hosted by Lawrence Cunningham who has recently published a 20th anniversary annotated transcript.

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Julia La Roche is a finance reporter at Yahoo Finance.

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