Do Vanguard and BlackRock Own Too Much of Corporate America?

Eric Posner is the Kirkland and Ellis Distinguished Service Professor of Law and Arthur and Esther Kane Research Chair at the University of Chicago Law School. Among his research interests is the question of the increasing concentration of ownership in corporate America, including the role of institutional investors.

A recent paper he cowrote, in which he proposes limiting the companies an index fund can own in one industry, caught our attention, and we wanted to learn more. We talked with Posner on two occasions in the fall. Our conversation has been edited for clarity and length.

Morningstar: Eric, how did you become involved in this topic of concentrated ownership?

Eric Posner: I was brought in by Glen Weyl, who is an economist at Microsoft Research. Glen and I have worked on many different academic projects together. Glen had read papers by José Azar and others that found a strong correlation between common ownership by institutional investors and prices that the firms that they own charge customers.1 Glen was immediately struck by how powerful this work was and asked me to write a paper with him.2 Fiona Scott Morton joined us as well. Because I am a law professor, I could provide some of the legal background and analysis to our paper.

You’ve worked with them subsequently as well.

Posner: Yes. We wrote a paper together, and we wrote some op-eds. Glen and I are writing a book now, which will come out in early 2018, in which we discuss a range of problems with the modern market economy in the United States and in developed countries generally. We have a chapter where we dig a little deeper and talk about the ultimate source of this problem.

Can you give us any hint as to what research directions you might be going there?

Posner: Sure. We are interested in historical developments going back to the 19th century. There is a general tendency of capital markets to become concentrated. The government or antitrust authorities react, but then there is this kind of arbitrage. The capital markets adjust to work around the constraints created by the government. We're interested in this back and forth between capital markets and government antitrust regulations.

One of the things you argued in your paper was that under current antitrust law, claims could be made against companies like Vanguard and BlackRock. Could you give us a summary of how antitrust law applies here?

Posner:

Under Section 7 of the Clayton Act,

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it’s illegal for investors to buy shares of companies if the effect of the purchases would be anticompetitive. This is a very broad rule. Now, there are exceptions and defenses, which I will get to in a moment. But just as an initial matter, if you or I, in our individual capacity, buy shares of

But if it’s an institutional investor that already has a large stake in rival companies within a concentrated market and it increases those stakes, and if one can show empirically that the effect of those purchases is to reduce competition among the underlying firms, then you’ve met that standard.

Now, nothing in law is as simple as it sounds. One of the major defenses is something called the passive investor defense or exception, which is also in that statute. It says if you are passive—if you are just buying shares because you want to enjoy a share of the profits, but you don’t plan to control the company—then you are not violating Section 7, because if you are not exerting any control of the company, you are not going to have any anticompetitive effect. The institutional investors will argue—maybe they already have argued—that they fall within this passive investor exception.

There are other sorts of complications and questions, but antitrust law is a flexible area of the law, and of course, [lawyers] are often aggressive or creative. I think the legal merits boil down to an empirical question of whether these purchases really do have an anticompetitive effect. That’s why these empirical studies are so striking and important, as they suggest that it’s the case.

Given that there are papers from economists on both sides of this issue, how would that affect the legal process? Presumably the defense would bring out one set of papers and plaintiffs would offer another set.

Posner: There are a lot of answers to your question. There are some papers that have been written that I just don't think are nearly as strong as the papers on our side. How these papers would be used would depend on what type of litigation we're talking about.

It’s very unlikely that someone is just going to sue all the institutional investors for all the anticompetitive effect they have had on the whole economy. Such a claim is just too broad and vague. What might happen is that someone might bring a lawsuit against institutional investors solely for their effect on the airline industry or for their effect on banking. Those could be separate lawsuits.

Right now, there is one paper on the airline industry as far as I know. What would happen in litigation is that the plaintiff would say, “Here is this paper,” and they would probably try to get the authors to testify as experts, but even if not, they would hire other economists who are experts. Those experts would say to the court, “We have all this empirical evidence that the institutional investors have reduced competition in the airline industry with the result that prices are higher.”

Now, the defense would hire their own experts who would have access to the same data, and they would do their own analysis of that data. And maybe those experts would be able to find other data that the first set of experts haven’t seen yet—from the airline industry, for example, or the institutional investors might be able to supply them with data. So, they would write their own report, and this other report would most likely say, “No, nothing is happening; there is no problem.” And it’s just up to the court to figure out who is right.

Do you think the debate has reached a point where you could see such lawsuits? Is there enough evidence out there?

Posner: Yes. I believe that the plaintiffs would have a strong case, and for that reason, it's just a matter of time before somebody brings a lawsuit. There has always been a lot of litigation against the airlines for all kinds of stuff, all kinds of anticompetitive behavior, and it's just a matter of time before the plaintiffs bring in the institutional investors and argue that they are either implicitly or explicitly coordinating the airlines.

Growing Issue Our view, given the trends in the industry toward passive and scale advantages of the likes of Vanguard and BlackRock, is that this will only become more of an issue over time, making it more likely that policymakers will get involved.

Posner: Yes, absolutely. If you look at graphs that show the growth of the institutional investors and particularly the top 10 or the top four, it's just a matter of extrapolation. And there's no reason to think that their ownership is going to flatten out or go down. There's every reason to think it will continue to increase. Part of the reason it will continue to increase, of course, is that people are finding index funds more and more appealing.

One of the differences between this and some of the big well-known antitrust cases in the past, where the beneficiaries of the anticompetitive behavior were the shareholders of one or a handful of companies, is that here the beneficiaries are the millions of individual investors who have truly benefited from the reduction in cost brought about by index funds. Presumably this would be part of the calculus for policymakers in determining how big of an issue this is. How does that affect litigation or the outcomes of that litigation?

Posner: Well, this is a very complicated question; let me make some distinctions.

The great consolidation of the 19th century that led to antitrust laws being created in the first place did benefit consumers. There’s no doubt that gas prices went down because of [John D.] Rockefeller’s consolidation of the oil industry. There were huge economies of scale and prices went way down. Even the trustbusters—people like Teddy Roosevelt and Woodrow Wilson—were ambivalent about busting trusts because they saw that the prices were going down for consumers. But they also understood that the immense size of these companies posed a threat to market competition.

Another point is that many people don’t own stock. Rich people, the middle class, the upper middle class have shares in index funds. Most people have little exposure to the stock market or none at all. So, there is a good argument that this trend has contributed to inequality.

This is related to yet another point. Economists are increasingly arguing that market concentration has affected wages. As monopsony power over labor increases, wages are getting squeezed.

So, the overall effect is complicated. Workers are probably losing, wealthy people are doing very well, middle-class people are somewhere in the middle. Ideally you want policymakers to take all of this into account. You do want index funds to remain easily accessible. But there is no simple answer to this question, and certainly these sorts of considerations wouldn’t be a decisive defense to litigation.

Restricting Ownership Moving on to remedies, the one you lean toward is restricting ownership to, say, one company within a concentrated industry, as opposed to spreading it out. Is that still your opinion?

Posner: This problem is not something for which there is a clean solution. There are lots of different solutions. I think litigation is the natural solution. But the worry is, it's going to create a huge mess because litigation is unpredictable and the sort of remedies that courts make are specific to the particular dispute. The courts generally are not in the position to try to look at the whole problem in all the markets and figure out a remedy.

So, we’re approaching this from a different direction. What would rules look like that might address this problem? Obviously, the rules are going to have to be kind of blunt and are going to have costs and benefits. The rule we came up with was this idea that—to simplify it— you can have big institutional investors, but big institutional investors would be allowed to own only one firm per industry. Or you can have small institutional investors who could be fully diversified; they can own all the firms in one industry, but they just have to have less than a 1% [market] share.

If our rule were put into place, we would predict that the market would segment, and you would see the big institutions like BlackRock divest from all the firms in a concentrated industry except for one and increase the stake in that remaining firm. BlackRock might have, say, 10% of United and 0% in the other airlines. In the meantime, you could see lots of smaller asset managers who could have 1% in all the airlines. That’s the idea. Now, it’s easy to poke holes in this solution because by design it’s simple.

In your paper, you make a fair amount of a study from Campbell et al. that argues you can achieve diversification by investing across industries.4 But no matter what the strategy is for diversifying across industries, if you’re only holding one company in each competitive industry, some investors would end up worse off. Wouldn’t you create a long tail of bad outcomes for, say, the person who ended up holding Pan Am in the mid-1980s instead of United Airlines?

Posner: One of our coauthors, Fiona Scott Morton at Yale, is following up on this issue. She is doing an empirical analysis of this diversification question. She is doing simulations involving different portfolios to see how much you lose—how costly it is for people to lose this additional amount of diversification. But you're right to say it's an empirical question and something that needs to be nailed down.

One problem is that people would have to search out and find the small [asset managers]—the 1% companies—if they want to be fully diversified. I know who Vanguard is. I know who BlackRock is. But there are a lot of financial companies I’ve never heard of and that maybe I’d be nervous about giving them my money. Or I could stick with Vanguard. I would just be slightly less diversified. Our initial view was that the cost would be low because the amount of diversification an ordinary person gets by owning all the companies within one industry as opposed to companies across industries is very small, because the stock prices of companies within an industry tend to be highly correlated.

If I am just an ordinary person and I want to be fully exposed to the stock market, there is not a whole lot of difference between owning stock in one company per industry as opposed to owning stock in every single company in the market. That’s why the S&P 500 is probably fine for most people. They don’t really need to own stock of 2,000 companies or 10,000 companies. So, mathematically, the additional diversification benefit you get is small.

So, either the lost diversification or, as I noted earlier, the cost of diversifying by contracting with small asset managers is the price of our rule. We think that the costs are less than the benefits. There are, for example, very high airline ticket prices relative to what you would have otherwise. If I were in Congress, I wouldn’t necessarily implement our rule tomorrow, but we would like to get some debate about it going.

Looking at the ownership stakes of Vanguard and BlackRock today, it’s already approaching 6% to 7% of each company. If they were to concentrate in one company and if their market share continues to grow, you could imagine a case where Vanguard owns a majority or close to a majority of one competitor and BlackRock owns close to a majority stake in another competitor, which seems to bring a whole host of other questions into play.

Posner: Right. This could happen, or it might not happen because BlackRock or Vanguard might divide. They might become smaller. But yes, it could happen. And then the question is, would this be a bad thing?

There are different theories about this. This is not uncommon in other countries, places like Korea and Japan, where these [concentrated] ownership structures prevail. The worry would be that the institutional investors might collude with each other and cause their underlying firms not to compete. They might have a stronger incentive to do that. Of course, that will remain illegal.

It would be a new world that would have to be addressed. I don’t see any reason in theory to think that it would be worse, but we wouldn’t know for sure until we entered that world. A lot would depend on what they [firms like Vanguard and BlackRock] did. If they continued to be passive, as they claim they are now, there wouldn’t be any anticompetitive effect. The smaller, more active owners would presumably not be as diversified and would presumably try to get the CEOs of these companies to compete more. That would be fine. Then, it wouldn’t matter if BlackRock owned half a company.

But there would be complicated governance issues that would arise. As a legal matter, they might have more responsibility. So yes, I can see issues coming up. It would be good to see somebody do a rigorous analysis of this based on comparative work, looking at how this looks in other countries. But at the moment, I’m not worried about this.

Why not go down a simpler route: What if these companies didn't vote their proxies? What is the argument against that approach?

Posner: A lot of people have suggested that, and I think that's an appealing approach.

My worry would still be that CEOs would be less willing to compete simply because they know that their big owners do better if they don’t compete. That’s the big problem, which is not solved by limiting the voice of the institutional investors.

Somebody has to fire the CEOs, control the CEOs in some way. And if the CEOs think that the institutional investors will support them, even weakly, and if these institutional investors have large stakes in rival firms, then the worry is that they’re not going to compete as vigorously. That said, I think this is a reasonable view. In the final draft of our paper, which is not necessarily the one that everybody has been reading, we do give more weight to this view. We say that this would be a reasonable response to the problem.

Do you think that, in addition to the argument around concentrated ownership, the traditional tools of trustbusting could yield greater gains to consumers today?

Posner: I'm very much in favor of antitrust litigation. In the United States, the antitrust laws have been interpreted in a more relaxed way than they have been in the distant past, with the result that industries have become more concentrated than they used to be.

I think it’s a complicated question. You could make the argument that the Justice Department could just focus on the underlying firms rather than the institutional investors and maybe that would be sufficient if the concentrated markets were broken up. Then ownership by institutional investors would not be a problem. It’s only a problem when the underlying markets are concentrated. But that said, I think half of the markets in the country are highly concentrated, and they are highly concentrated because there are technological reasons why big firms are doing better than little firms.

Policymakers Take Notice Since you’ve started writing on the topic, what’s been the level of interest among policymakers? Do you think that there is interest, and has the level of interest surprised you on the upside or downside?

Posner: We started working on this paper before the presidential election. I know secondhand that people in the Justice Department were interested in the topic. I know that there's interest among European antitrust authorities.

Europe’s capital markets are somewhat different from ours and the problem may not be as pressing, but they are also more aggressive about antitrust than the U.S. government is.

As for the new U.S. administration—to be fair, they are just still transitioning, but I’d be skeptical that this would be a priority for them. There is certainly a lot of interest among academics and people who are interested in policy, but I suspect the problem of institutional investing will be a long-term issue.

What about the reaction among the fund industry? Have they reached out to you? BlackRock, for example, has written about this.

Posner: Right. I attended a conference in New York with representatives from the industry put together by NYU. They are obviously not happy about this work, but they seem willing to engage. What I'd like to see them do is provide data to independent academics. That would be the best way to settle the various controversies. I am not tremendously impressed with what they are writing. I think they are giving money to researchers to write stuff that they hope will support their view. I don't think that's a great thing.

Any closing thoughts?

Posner: One thing I have been thinking about a lot since we worked on this paper and for the book is the relationship between corporate governance and the role of institutional investors. I'm quite struck by the bind that institutional investors find themselves in. On the one hand, I do believe them when they say that, at least for index funds, they'd like to just be passive. They don't want to actually have to vote. But on the other hand, the government forces them to, right? They're not allowed to be passive.

There is a paradox here, which goes to the root of how corporations are organized. For decades people have understood that even the old model of corporation, where they were owned by dispersed shareholders, was paradoxical. You had all these owners who didn’t exert any influence over the corporation or the other shareholders. So, the managers just got to do whatever they wanted to, which is certainly not ideal. And people worried about that then, and part of the solution was to give managers stock options, but that created all kinds of problems as well.

When institutional investors started buying up large chunks of these firms, 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.

There are some deep questions that the debate about institutional investors doesn’t really get to the heart of. These are deep questions for which there are no easy answers. So, I’m not going to give you an easy answer here. But I do think that it’s a big part of the puzzle.

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

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

3 The Clayton Antitrust Act of 1914 strengthened and expanded the rules established by the Sherman Antitrust Act of 1890.

4 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.

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