Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Does the uptake of passive strategies reduce competition within industries? Joining me to share his take on that thesis is Alex Bryan. He is director of passive strategies research for North America for Morningstar.
Alex, thank you so much for being here.
Alex Bryan: Thank you for having me.
Benz: Let's discuss how actively managed funds tend to differ from their index fund counterparts in terms of how they assemble portfolios. Your typical active manager might take a position in one or two companies within an industry and might bet more heavily on those companies. Actively managed products tend to differ from index funds in this respect. The index funds would tend to assemble more diffuse portfolios. They would tend to own all of the companies within an industry, right?
Bryan: That's right. Index funds typically will own all the stocks in the index. A lot of times if you look at your broad market-cap-weighted funds, that's going to include most stocks in an industry. That means you are going to own competitors, both Ford and GM. Active managers, in contrast, oftentimes will have more concentrated exposure to the names in a given industry that they think are the most promising. They might have a bigger concentration in Ford than an index manager, for example.
Benz: It's not immediately intuitive why the uptake of index products would lead to less competition in industries. Can you walk us through that thesis, why that assertion might be made?
Bryan: The thinking is that if you own several competitors within the same industry, your incentive is not necessarily to maximize the value of your individual company but rather to maximize the value of the entire industry. You might behave in a way that a more concentrated owner would not by using your influence as an owner in many different competitors to discourage competition to maximize industry profits or to not pressure individual companies to compete as aggressively as a more concentrated shareholder might.
For example, let's say, I invest in both American Airlines and Southwest. On both of those companies I would prefer them to compete less aggressively than they otherwise would if I just invested in one or the other.
Benz: You would prefer them to, kind of, pick their markets and charge as much as they can for them and not compete head to head, for example?
Benz: Let's talk about your thesis, which is that, you don't think that at this point at least this is a big deal and certainly, not something that regulators should be approaching with a heavy hand. You don't necessarily think that the growth in indexing leads to less competition within industries. Let's talk about why that is.
Bryan: That's right. I don't think there's a strong reason to believe that increase in common ownership would lead to less competitive behavior because, number one, most corporate managers are heavily incentivized to act in their own firm's best interest. It's a stretch to imagine that I, as a corporate manager, would adopt less competitive behavior to help out my competitors when my compensation is tied to the value of my stock price and my bonus is tied to my profits and growth metrics and things like that.
Benz: And that's the case for most corporate managers today.
Bryan: Exactly. That's the first point. The second point is that this whole argument that an increase in common ownership leads to less competitor behavior is really the same thing as saying that if you took common owners out of the picture, it would be in firm's best interest to compete more aggressively with one another. And that's not necessarily the case. A lot of times if I were to compete more aggressively, that will elicit a competitive reaction that could actually hurt my profits. For example, let's say I'm American Airlines and I want to take market share away from Southwest and one way I might do that is by cutting prices on a particular route. Well, if I do that, Southwest is likely to respond in kind and we will both be left with lower profitability. Knowing that, it can be in both firms' best interest not to compete more aggressively. I think, most firms have already found the optimal level of competition given their competitive landscape. If you take common shareholders out of the picture, it's not necessarily the case that they would compete any differently than they already are right now.
Then if you take these two bits aside and you assume that this argument or the intuition behind it is right that maybe there is something to this idea that I would want to maximize the value of my portfolio, it isn't necessarily the case that index funds or common owners would stop at the industry level. They would have an incentive to maximize the value of their entire portfolio. It may actually be in my best interest to encourage more competition among airlines because airlines represent a very small part of most index funds' portfolios and most diversified portfolios. Airline prices are input costs for most publicly traded firms. More competition there might actually benefit me as a more diversified investor. I think it's important to look beyond what's going on at the industry level and to look more holistically at the impact of competition on the overall diversified portfolio.
Benz: Let's take a a look at the specific industries that you referenced were examined in the study, banking and airline industries. Are there any particular things going on in these industries or things that were going on in these industries over the time periods examined that maybe make them somewhat anomalous and not necessarily representative of corporate America as a whole?
Bryan: The time period that both of these studies were looking at, trying to tease out the impact of an increase in common ownerships on competitive behavior, they were looking at data from the early 2000s on through about 2014. During that time period, in both industries, there is a tremendous amount of consolidation, where lots of airlines were merging and many of them went through bankruptcy and emerged from bankruptcy which more rational pricing strategies. The same thing happened in the banking industry.
It's really hard to disentangle that effect from the impact of an increase in common ownership. Obviously, index investing has become more popular over that time period but also there has been an increase in concentration in those industries. It is very difficult to isolate the impact of common ownership on competitive behavior. In order to be convinced that this is something you should be worried about, I really do think there needs to be more empirical evidence of this in other industries and in other markets. I think it's really too early to act on this preliminary research because there is no really good theoretical underpinning for the argument.
Benz: Interesting research. Thank you so much for being here to discuss it with us.
Bryan: Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.