Index-Fund Imbroglio

This issue of Morningstar magazine contains two articles, besides this one, that consider the possibility that the growth of index investing has contributed to corporations' abnormal profitability. In "Do Vanguard and BlackRock Own Too Much of Corporate America?", the University of Chicago's Eric Posner answers, "Yes." Morningstar's director of policy research, Aron Szapiro, then considers legislative remedies in "Would Policymakers Target Index Funds?". Ideally, readers will proceed in that order: Posner first, to establish the case; then Szapiro, to understand the possible Washington responses; then, finally, this article, which complements the other two.

From Industry to Academia The claim that index fund managers—or, more generally, any institution that invests so widely as to hold multiple stocks across the nation's industries—are soft on corporate CEOs is, of course, scarcely the first charge to be levied against indexers. Traditional investment managers have disliked index funds ever since they were introduced.

Indexing’s competitive threat has sparked 40 years of attacks from active managers. Buying an index fund, they state, means settling for mediocrity. Index funds are losers, because after expenses they trail their benchmarks. Indexing creates stock-market bubbles, because index funds invest mindlessly, without regard for valuations. Indexing distorts security prices, inflating the prices of stocks held by the major indexes, while depressing those of the outsiders.

Not only were those arguments weak, and thus largely ignored by the shareholders they targeted, they also remained outside the courtroom. Nobody filed lawsuits against indexers or sought regulatory changes. The battle between the incumbent investment managers and the upstart indexers was waged in the business world. To the victor went the spoils.

There is a new critic in town, however. This one has greater credibility than the self-interested active managers. That critic is the academic community—the very community, of course, that fostered the very notion of the index fund and that, until now, has been such an enthusiastic supporter. The parents have turned on their child.

Is Competition Insufficient? A recent paper, "Anti-Competitive Effects of Common Ownership," by José Azar, Martin Schmalz, and Isabel Tecu, gives the thesis.1 Indexers harm society. Index funds, they say, encourage CEOs to behave as semimonopolists, while overpaying themselves.

That paper has quickly attracted attention, being the right paper for the right time. The United States currently offers two major economic puzzles:

1. Why have almost 10 years of low interest rates (and quantitative easing) not triggered inflation?
2. Why do U.S. corporate profit margins set new highs each year?

The authors answer the second of those two great questions.

The paper’s thesis: In large part, profit margins have become elevated because a handful of huge index fund providers own everything. All the major U.S. companies. Such “common ownership,” as the authors term it, discourages competition. Index funds don’t want CEOs to compete, because one company’s gain becomes another’s loss. They want CEOs to coexist peacefully, by implicitly (if not explicitly) colluding so that their prices remain high, and the wages they pay to labor are low.

This is how Posner states the matter: “When institutional investors started buying up large chunks of [corporate America], people were writing how this could be a good thing, because now you’d have shareholders who are large enough that it would be worth their while to exert control over these corporations. But the problem is that if they also own rival corporations, they may exert the control over these corporations in a way that’s not beneficial to the public.”

Note that the academic strike against indexing is more profound than the assaults by active managers. The latter merely suggest that indexing disrupts the functions of the stock market. The academics, on the other hand, suggest that indexing has helped create fundamental social problems, such as rising income inequality and overly high prices paid by consumers.

Counterpoints It's worth noting that while this hypothesis has attracted much academic attention, and is now starting to appear in Washington policy discussions, it hasn't yet convinced many investment professionals. The argument is circumstantial; it consists of regressions that show correlation, without demonstrating the reasons for those relationships. The authors have one explanation, but others are certainly possible.

Indeed, many researchers account for abnormal corporate profitability with other explanations. The decline of organized labor and of the national minimum wage (if inflation-adjusted), along with increased automation, has reduced many companies’ costs. According to Morningstar’s research, industry characteristics have also changed, such that more companies now boast wide moats that support margin expansion.

("More Moats, More Profits,") The case against common ownership (and thus index funds) will require considerably more evidence to be proved. For the purposes of discussion, however, let's assume the case has been won and evaluate some proposals for redressing abnormally high corporate profitability.

The Breakup Plan: Indexers Posner makes an immodest proposal, from Jack Bogle's perspective: Break up the giant index funds. "Big institutional investors would be allowed to own only one firm per industry." Smaller institutional investors, defined as those with less than a 1% market share, would be permitted to own more, but the giants would not.

Such an action would ban the index fund as we know it, if it came from Vanguard, BlackRock, or State Street. Such an “index” fund would need to operate by sampling, limiting itself to one issue per industry. Posner points out, accurately, that such an approach preserves most diversification benefits. (Indeed, sampling is a common practice with fixed-income and international-stock indexes.)

Bogle, unsurprisingly, is not amused. In addition to disputing the argument that indexers enable corporate misbehavior, he points out the practical difficulties in enforcing such a ban. First, there would be tax consequences for investors in the existing index funds that would need to unwind positions to conform to such a regulation. Second, who gets Amazon.com AMZN? Or Apple AAPL? Imagine running an index fund when you weren’t permitted to own the year’s single best-performing stock—but your rival was.

Szapiro doesn’t see any such regulation occurring under the current Washington administration. However, he believes that the Democrats could, conceivably, include dismantling the index giants as part of a populist platform during the next election cycle. There would be resistance because middle-class investors benefit from the low costs of indexing, but the possibility exists.

The Breakup Plan: Companies Another way to reduce corporate profitability could come from the executive branch. Posner argues that the U.S. pendulum swings from high vigilance when enforcing antitrust laws to low vigilance, and that the United States currently is near the low point. On that ground, he has much support. Investment manager Jeremy Grantham has written similarly, as have other investment professionals. Using antitrust statutes to disassemble companies and industries is neither novel nor radical; it has a mainstream U.S. history, dating back to Teddy Roosevelt.

Once again, such actions are unlikely over the near term. Neither the Trump administration nor the Republican-dominated Congress shows any inclination to litigate against multinational firms. For Democrats, however, taking on corporate behemoths would be less problematic than attacking index funds. Such activity is likely should the Democrats regain control in Washington.

Corralling the Chiefs In addition to Posner's two suggestions involving index funds and antitrust provisions, there is a third option: Going after CEOs. Such an approach has the advantage of directness. After all, according to Posner's own logic, the reason that corporations now have abnormally high profits—and consumers abnormally poor conditions—is because of choices that corporate managements make. They may be aided and abetted by index funds, and by a complacent federal government, but ultimately the crime is committed by the CEOs.

Want to stop a leak? Plug the source.

Here is my thought. Corporate chiefs are currently rewarded for profitability, as manifested by stock-price performance. So, change the rules on compensation. Require that CEOs be rewarded instead for growing their companies’ market shares. Or, perhaps, they should be paid on relative rather than absolute stock-market gains, such that if a company’s stock rose 30% on the year, and the industry average was 35%, the CEO goes unrewarded.

Such ideas, obviously, need refinement. But the point remains. It may be that index funds have failed at corporate governance, and it may be that because of this failure their power should be removed. However, the case against indexing has not yet been made, and even if restitution is ultimately called for, it need not necessarily lead to the restructuring of index funds.

1 Azar, J., Schmalz, M., & Tecu, I. 2017. “Anti-Competitive Effects of Common Ownership.” Journal of Finance, forthcoming.

This article originally appeared in the December/January 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.