Like many other people I have a stocks and shares ISA that puts my money into a set of index funds, which are baskets of investments in every publicly traded company in various stock markets, weighted by the market cap of each company. Effectively, it allows me to invest in ‘the market’ as a whole, with investments proportional to the size and value of the firms as judged by active investors. It is cheaper and less risky than trying to ‘beat the market’ with an active fund manager, and since I believe that financial markets are quite efficient I don’t see much point in trying that anyway.
The two biggest firms that run ‘passive’ funds of this kind, BlackRock and Vanguard, manage over ten trillion dollars between them. An interesting Bloomberg article raises the possibility that this could lead, effectively, to collusion within markets, and create effective monopoly control even in markets that appear to be competitive.
The logic is straightforward enough. If all major players in a sector are part-owned owned by, say, Vanguard, there is an incentive for the owner to instruct firms to compete less and maintain, across the board, higher prices than would be impossible in a competitive market.
There is some evidence that this is happening: some recent papers suggest that increased ownership by ‘passive’ institutional investors was associated with higher airfares and banking prices in the United States. The airline study is particularly interesting because the data is so rich. Usually separating cause and effect in price rises can be pretty difficult, but since there are so many different airline routes, each effectively operating as a separate market, with such good public data on prices, etc, there’s more scope for like-with-like comparisons that minimise confounders.
Factoring in this kind of ownership, market concentration is ten times greater than what conventional measures suggest is a threshold for anti-competitive activity. Concentration is an indication, not proof, of monopoly power, but prices also rose as well when passive fund ownership rose. When, for example, a privately-owned airline like JetBlue went public and hence became part-owned by the same index funds that part-owned Delta, American Airlines, etc), prices would rise by 3-7% on that route. The study includes several methods of testing causation, including a demonstration that prices are not rising because of greater passenger demand – in fact, passenger volume falls as passive investor ownership rises, consistent with the oligopoly thesis. Similar results were found for banks.
If this is really what’s going on, then it’s potentially a very big problem. But there are a few questions that linger. Are company managers actually being told by BlackRock and Vanguard that their individual firms’ profits don’t actually matter, and they should try not to rock the boat? Are these investors helping to appoint managers that they expect will be worse than other candidates, intending to depress competition in the sector?
It’s not even clear that the managers of these funds actually are trying to maximise their funds’ returns, as opposed to straightforwardly managing them and mechanically making sure they’re doing what they’re meant to – reflect the market. So do the fund managers themselves have an incentive to promote maximum returns? The mechanism proposed by Azar et al is less sinister: that firm managers prefer a ‘quiet life’ and won’t act competitively to boost their firms’ profits unless they’re pushed into doing so by their investors, and passive investors are just that – passive.
Even if all this was right, we’d generally expect this sort of situation to be unstable in markets where entry costs are reasonably low – there is basically money on the table for a firm that is not part-owned by the index funds to come in and grab through more aggressive competition (like privately-owned firms). In sectors where barriers to entry are high, then of course this is less likely to happen in the short run, and it may not happen at all in markets where entry is impossible (eg, utilities markets where adding new infrastructure isn’t possible).
What’s more, though, index funds are usually country-specific – Vanguard has a US fund, a UK fund, and so on, and these are run by different people. Why aren’t foreign firms, which may find it easier to compete than startups, entering these markets if cartel-like behaviour is going on? Here I think it’s important to note that that both airlines and banking, in the United States, have quite strict rules that hurt foreign firms’ ability to compete. Non-US airlines simply are not allowed to run domestic flights in the United States, and the fact that financial regulations are both stringent and in many respects very different to other countries’ may remove the advantage that we’d expect an existing firm to have entering a new market. It could be that in markets like these, this effect takes place, but that it doesn’t generalise outwards.
Or maybe the problem is illusory altogether. A Federal Reserve paper from early 2017 proposed a different way of measuring the effect on competition of common ownership, which tries to estimate in the case of banks how much ‘weight’ firm managers would put on their own firms’ profitability compared to that of their rivals under different levels of common ownership, and finds a very small effect. Another, by one of the same authors, argues that activist investors (who try to influence corporate decisions) are strengthened by passive investors, which would militate against the ‘quiet life’ theory.
If this is a real issue, there are several options that could fix it. One, proposed by Eric Posner and Glen Weyl, would be to limit how much of a certain ‘industry’ a fund could own or to limit ownership to a single firm in each industry. This would defeat the point of index funds, though – they would cease to be impartial reflections of the market as a whole. A more light-handed approach might be to take away these funds’ voting rights above a certain fraction, so that their influence over firm management was limited but their ability to produce returns and diversify was not.
Alertness to the dangers of monopoly is important as well, though – if airlines and banks are special cases because of regulation, that is an argument for deregulation that opens up those sectors to greater competition from overseas. If it’s a broader problem, that might not be enough and we may need to intervene in some way. But those eager to rapidly put constraints on passive investment should be careful. Index funds are a convenient and relatively safe way for normal people to invest for the future. The costs of pushing them into a riskier and more volatile sector, or drying up their investment entirely, could well be worse.