Would Policymakers Target Index Funds?

A small but growing body of provocative literature has argued that when institutional investors own large shares of competing companies, it results in higher prices for consumers. This literature has profound implications for policymakers looking to promote competitive markets.

For example, Azar, Schmalz, and Tecu (2017) conclude that the government should restrict institutional investors from owning competing firms if the anticompetitive effects of common ownership are not outweighed by the efficiency-enhancing effects of diversification. Others have already suggested policy responses to concentrated ownership, most notably Posner, Morton, and Weyl (2017), who would restrict asset managers from owning more than one company in a competitive industry.

This debate may seem academic, but it may find a receptive audience among politicians, at least among Democrats. With the release of their Better Deal policy document, Democratic politicians signaled they plan on running for election in 2018 on a campaign of breaking up unpopular monopolies (albeit without yet naming large asset managers as a target).

As these ideas jump from economics and legal literature to policymaking, policymakers will need a framework for evaluating whether the potential costs of concentrated ownership are, in fact, greater than the benefits. As Azar et al. conclude, “Which effect prevails is an empirical question that goes beyond the scope of our paper, which merely intends to start the debate.” This short column will not answer the question of which effect prevails, either, but it seeks to ascertain the key questions that policymakers need to ask to develop a framework.

The Benefits of Index Funds Dramatic changes could be required to eliminate any anticompetitive effects of common ownership of competing companies. For example, Posner et al. explore a few solutions before concluding that an institutional investor should own no more than one company in a potentially uncompetitive industry unless the investor owns less than 1% of the market share.

Further, the paper argues that no institutional investor should communicate with top managers or directors of such a firm. (According to Posner et al., a potentially uncompetitive industry is one where a few large companies do not compete for market share. They call this an oligopoly and define it using a mathematical formula for competition, although they envision regulators would have discretion to designate oligopolies.)

This novel approach has the potential to dramatically change the operations of index funds; it could fundamentally turn them into active stock-pickers. After all, active funds constrained from owning, say, multiple airline companies could continue to use the tools of active ownership to determine in which airline to invest. So, the rule, while a constraint, does not alter the value proposition of an active fund the way it does a passive fund.

To quantify the costs of such a change, policymakers first need to understand how many people benefit from index funds. More than 50% of Americans have retirement savings accounts. Changing one of the key innovations in retirement investing over the past 30 years directly affects 57 million households, according to our analysis of the Survey of Consumer Finances. In short, such a shift would not only affect a small number of institutional investors profiting from concentrated holdings in leading companies but also many Americans saving for retirement.

Another critical question is the importance to investors of the diversification that common ownership provides. Common ownership is a necessary byproduct of diversifying in a single fund. If a fund has the goal of providing broad ownership of the stock market to achieve diversification, it is necessarily going to hold shares in competing companies. Posner et al. cite Campbell, Lettau, Malkiel, and Xu (2001), who argue that the volatility of not diversifying across companies can be mitigated by diversifying across industries. But how robust is this finding over time? Presumably, some investors will end up investing in the airline, bank, or technology company that doesn’t perform well or is driven out of business by competitors. Will this create a “longer tail” of failed retirement accounts by increasing the idiosyncratic risk retirement savers and other investors take on in their investments? Indeed, Morningstar has found that most returns earned by investors can be attributed to the growth of the upper 20% of successful companies—growth many investors would miss if they were in funds forced to choose among leading companies, rather than owning several leaders in a broadly diversified fund.

Posner et al. argue that passive funds could randomly select companies within an industry and that investors could hold multiple funds with overlapping strategies to mitigate this problem. But this would have large ramifications for the retirement-plan market. Employers who offer 401(k) plans would have to offer new options and explain to employees how to use them. There also likely would be risks that such a novel approach would violate fiduciary principles. Further, asset managers would lose the economies of scale that have led to steadily decreasing costs for investors.

Which leads to another question: How broad are the benefits of index funds beyond their reduced costs for people who invest in them? Index funds have forced active funds to justify their higher fees and explain their strategies. They have put plan sponsors and IRA advisors under pressure to ensure they recommend active funds whose fees they can justify to their clients. Indeed, the asset-weighted average expense ratio for all funds fell to 0.57% in 2016, down from 0.61% in 2015 and 0.65% three years ago, according to Morningstar’s latest fees study (Oey 2017). The asset-weighted average fees for passive funds and active funds are 0.17% and 0.72%, respectively, according to our fees study. If index funds could no longer operate as they have, but had to pick which companies to invest in, what would the ripple effects be for investors? Keep in mind that the low costs of index funds are directly related to their simplicity. Add another layer of stock selection to the process of indexing, and investors can expect fees to go up.

Other Explanations for Abnormal Profitability In terms of the anticompetitive effects of common ownership, how strong is the available evidence, and where can we look for other proofs? What other explanations might there be for the abnormal profitability of publicly traded companies we have seen? And how can we drill down to the total costs of these anticompetitive effects, if there indeed are any?

As you’ll read in this issue’s Spotlight section, Morningstar’s analysts have found evidence as to why companies have become abnormally profitable recently. There are more wide-moat companies today than in the past. These firms operate in industries with a high barrier to entry and, thus, can charge higher prices. Or maybe, U.S. industries have become less competitive as fewer publicly traded companies compete against each other. (Such a problem suggests more traditional antitrust solutions.)

In other words, there is not conclusive evidence that asset managers with too much concentrated ownership are the problem—yet. That does not mean this could not become a problem in the future. I merely mean that we don’t have enough evidence to link the cause of higher-than-normal profitability to the anticompetitive effects of asset managers owning large shares of competing companies, rather than to other trends.

Finally, to properly perform a cost-benefit analysis on restricting mutual funds from common ownership of competing firms, we would need a clear empirical estimate of the costs to consumers. In the airline industry, Azar et al. estimate common ownership costs consumers an extra 3% to 7% in ticket prices. But what about other industries? And Azar’s airlines estimate is a wide range. The two ends of the range (3% and 7%) might yield different answers to a cost-benefit analysis, given the importance of index funds to a broad range of ordinary retirement savers.

Break Up Index Funds? It seems unlikely that U.S. policymakers are going to act on any of these ideas now, but that might change the next time Democrats are ascendant. A key centerpiece of their plan is the "Better Deal on Competition and Costs," which promises to "crack down on corporate monopolies."

There are two big reasons this line of argument will make for appealing rhetoric in the midterm elections and beyond. First, as income and wealth inequality has grown, there is a growing belief that the system is rigged, so running against monopolies is a good way to align that feeling with concrete policies.

Second, antitrust action allows politicians to talk about increasing equality without arguing for massive new bureaucracies, raising taxes, or redistributing resources in obvious ways.

The Better Deal plan does not mention asset managers but focuses instead on the usual suspects: airlines and cable and telecom companies, along with less-frequently talked about industries such as breweries and commercial agricultural seed companies—examples that seem crafted to appeal to Americans living in the heartland. However, most legislation tends to give broad statutory authority to regulators, who can fill in the details later.

In this case, should the Better Deal plan turn into legislation and eventually law, it would create a new consumer competition advocate, with broad authority to keep markets fair and open. Given the academic literature on common ownership among asset managers of competing companies, this could pave the way to new, novel forms of antitrust action, effectively ending broad index funds, thus raising the costs (and lowering the returns) of ordinary investors. Furthermore, high-profile Democratic senators (Cory Booker, Amy Klobuchar, Kirsten Gillibrand, and Al Franken, among others) are taking the idea seriously and recently introduced a bill (S. 1811) that would require the Federal Trade Commission to study whether common ownership of companies by asset managers affects competition.

Evidence Needed Before Action None of this is to say we should not treat arguments about concentrated ownership seriously. As the great political theorist Albert O. Hirschman argued in The Rhetoric of Reaction, people opposed to policy reforms have argued for centuries that a reform will perversely result in the opposite effect of what policymakers wish or jeopardize a positive status quo. The questions raised in this article could be viewed as an endorsement of the status quo. On the other hand, we prefer to err on the side of the known advantages of index funds, as opposed to the putative gains from their disruption, until there is more evidence to resolve the key questions around the costs and benefits of a policy response.

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

Campbell, J.Y., Lettau, M., Malkiel, B.G., & Xu, Y. 2001. “Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk,” The Journal of Finance, Vol. 56, No. 1, February, pp. 1–43.

Oey, P. 2017. “U.S. Fund Fee Study,” Morningstar Manager Research white paper, May 23.

Posner, E., Morton, F.S., & Weyl, E.G. 2017. “A Proposal to Limit the Anti-Competitive Power of Institutional Investors,” Antitrust Law Journal, 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.