Index funds are rational for everyone, but could make everyone collectively worse off in the model
When diversification becomes cheap enough, money flows from individual stocks and bonds into equities, driving up share prices and depressing expected returns—everyone makes the choice optimal for themselves, yet the result might be that everyone ends up worse off. This is a tragedy of the commons.
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Index funds are rational for everyone, but make everyone worse off in the model
In Schmalz and Bill Zame's equilibrium model, index funds make diversification cheap, so more people shift money from bonds and individual stocks into equities. By supply and demand logic, increased demand raises share prices and depresses expected returns. Risk falls, but so do returns—in this simple model they perfectly offset each other, leaving every investor worse off than without index funds, despite each making the choice optimal for themselves. Schmalz stresses this is only a theoretical possibility, not a claim about reality.
— Martin SchmalzCommon ownership cannot be blamed solely on index funds
After examining all U.S. publicly traded companies' shareholding records over the past decade, Schmalz found that what actually drives ‘the same shareholders holding competing companies’ is often not index funds but concentrated holders like the Bill Gates family office holding multiple companies in the same industry, or Berkshire's massive stakes in multiple banks and airlines. Even when index funds are involved, common ownership arises not from the funds themselves but from concentrating all fund voting rights in a single corporate governance office that votes with one voice.
— Martin SchmalzAirline ticket prices: one merger became a natural experiment
Schmalz uses BlackRock's 2009 acquisition of Barclays Global Investors as an exogenous shock—this deal clearly had nothing to do with New York-to-Boston airfares, yet unexpectedly altered U.S. airline shareholding structures. The result: on routes where common ownership increased (assuming combined holdings added up), ticket prices rose more over the following years, and this relationship was predictable in advance.
— Martin SchmalzBuffett and Fink never personally push their portfolio companies to compete
Schmalz distinguishes two mechanisms: either investors call competitors to coordinate pricing, or large shareholders simply lack incentive to push their portfolio companies to compete. Richard Branson might personally get involved helping Virgin Atlantic grab market share, but no one has seen Buffett or Larry Fink do so. The issue is not ‘enabling collusion’ but ‘lacking motive to compete’—which determines what evidence to use and what policy response is appropriate.
— Martin SchmalzStripping index funds of voting rights sounds simple, but no one has modeled consequences
One frequently proposed policy is to strip large funds of voting rights. Schmalz once thought this absurd—if the 73rd-largest shareholder suddenly became the effective controller, agency problems would explode. But he later realized that once rules change, the entire shareholding structure reshuffles, and existing financial models treat shareholding structure's feedback on corporate competition and stock prices as exogenous. ‘We have almost no concept of what consequences these policies would bring.’
— Martin SchmalzThe character that builds wealth systematically destroys investment returns
Many family fortunes shrink dramatically within one or two generations. Schmalz attributes this not to depleted luck but to wealthy individuals lacking true diversification or bearing excessive costs. The deeper cause is the entrepreneur's personality traits—trusting handshake agreements, overconfidence, relying on intuition, craving control—which enabled their success as founders but systematically prevent them from being good investors, because investing requires due diligence, risk calibration, and deliberate decision-making rather than trust and gut feel.
— Martin SchmalzSome pay fees for a fund that won't return their money to escape volatility
Schmalz uses a bungee-jumping analogy: people only truly fear falling from a cliff, and this horizon-dependent risk aversion—where fear intensifies as danger approaches—explains why volatility spikes cause panic selling, and when panic subsides people buy back in at higher prices. For these investors, paying a management fee to lock money with a fund they ‘can't call’ with ‘lock-up periods’ in place, even if it underperforms the market, beats making destructive market-timing decisions amid volatility. Cliff Asness calls the practice of allocating to illiquid private assets to avoid volatility exposure ‘volatility laundering’.
— Martin SchmalzTwo percent annual costs consume half a generation's wealth
With 7.2% annual returns, the rule of 72 makes wealth multiply 16x in 40 years—a common rule of thumb. But if annual costs add 2%, returns drop to 5.2%, and after 40 years wealth doesn't fall to 80%—it becomes only about half of 16x, or just over 7x. Schmalz notes this 2% cost easily accumulates unnoticed across asset management fees, custody fees, withholding taxes, legal and accounting fees, and private equity due diligence costs, especially for smaller family offices.
— Martin SchmalzIn their own words · checked verbatim
I've never seen Warren Buffett or Larry Fink put on lipstick and try to help Delta win market share from United.
Martin Schmalz27:00
If each household owns the same fraction of a firm as its share of consumption, then shareholders unanimously want marginal cost pricing.
Martin Schmalz29:01
entrepreneurs have personality traits that make them successful as entrepreneurs that quite systematically kill them as investors
Martin Schmalz46:40
cliff asness calls it volatility laundering when people just make private market investments not because they believe that they produce alpha vis-a-vis the stock market but because you can't sell them when volatility goes high
Martin Schmalz56:57
a 2% cost per year eats half of your wealth in a generation, not half your returns, half of your wealth
Martin Schmalz1:04:13
Figures
| Vanguard index fund fees around 1980 | 76 basis points per year | 6:11 |
| BlackRock's acquisition of Barclays Global Investors | 2009 | 23:56 |
| Share of top three asset managers in large US stocks and REITs | approximately 20%, some approaching 30% | 21:53 |
| Stock market value affected by relevant regulatory rules | approximately 70 trillion dollars | 1:14:34 |
Glossary
- common ownership
- When the same shareholders simultaneously hold multiple competing companies.
- horizon-dependent risk aversion
- Risk aversion that intensifies as danger approaches in time, rather than treating all time periods equally.
- tragedy of the commons
- A situation where individual rational choices lead to collective harm.
- volatility laundering
- Using illiquid private assets to obscure exposure to market volatility.
How to listen
Investors concerned about index funds' long-term side effects; policy analysts studying antitrust and shareholding structures; wealth managers serving family offices.