Devil Investor

Are Index Funds Evil or Just a Scapegoat for a Much Bigger Concern?

Devil Investor

In the September 2017 issue of The Atlantic magazine, an article entitled “Are Index Funds Evil?” caught the attention of many passive investors.

The crux of the argument made has to deal with shareholder diversification and its effect on corporations. According to the article's author and index fund proponent, Frank Partnoy:

“Concerns about the potential dangers of shareholder diversification first surfaced back in 1984, not long after index funds themselves did. Julio Rotemberg, then a newly minted economist from Princeton, posited that ‘firms, acting in the interest of their shareholders,’ might ‘tend to act collusively when their shareholders have diversified portfolios.”

Why would this be the case? If corporations’ sole motivation was to maximize shareholder value, they could do so further by colluding to stifle competition and thus monopolize (or maybe more like “oligopolize”) their individual industries to raise prices and increase profits for themselves at the expense of non-shareholders. Since diversified shareholders hold a stake in each company, they would benefit from this behavior. 

First point we want to make is that common ownership and shareholder diversification are not just associated with index funds. Actively managed funds that hold more than one individual stock in any particular industry are subject to the same criticism. If someone wants to make the case that common ownership and shareholder diversification are creating problems for the overall economy, they cannot just disparage index funds.

Now of course this sounds possible in theory, but is there any empirical research to confirm it? The article cites a research paper titled “Anti-competitive Effects of Common Ownership” by Jose Azar, Martin Schmalz, and Isabel Tecu, which specifically analyzed the airline industry. The article presents some of the research paper’s conclusions:

“Overall, it said, the high concentration of share ownership had caused serious harm to consumers in the airline industry: Ticket prices were as much as 12 percent higher than they otherwise would have been, because of common ownership of shares. The authors measured how competitive individual routes were, based not only on how often each airline flew a given route—which regulators already examine—but also on the degree to which each airline’s shares were held by common investors. They found that adding common ownership increased the level of concentration on the average route to more than 10 times higher than the levels that regulators presume to be the problem.”

But this explanation of course could be suspect to spurious correlation, which leads us to our second point. As the article properly cites, while common ownership has increased over the last two decades, so has market concentration through mergers, acquisitions, and bankruptcies. For example, most major airlines have merged (United and Continental, Delta and Northwest, American and US Airways, etc.). Is this because shareholders of these companies vis-a-vis index funds are urging this type of behavior? Or is this just the natural course of capitalism, in general? 

It seems too easy to possibly blame common ownership. Index funds have been called a lot of things over their lifetime – “un-American,” “parasitic,” “communist,” and now we have “evil.” Pegging them for the responsibility for the low-growth outcomes associated with anti-competitive corporate decisions would be too simple. In fact, the article points to some of the economic ills that common ownership has been scapegoated for:

“An array of new research blames common ownership for various ills, including high bank fees and stratospheric CEO pay…One journal article argues that large index funds are violating antitrust law.”

Let’s think about this for a second. Does it seem reasonable that the likes of Vanguard, Blackrock, or Dimensional Fund Advisors are using their ownership muscle to influence the corporate board’s decisions to break U.S. anti-trust laws? 

Most index investors see the merits of market competition as it can lead to innovation, lower costs, and more efficiency in terms of how resources are allocated and utilized. Competition, specifically in the capital markets, is the reason why many investors decided to start index investing in the first place. Why bite the hand that feeds you?

Many of the fund companies that do have a large amount of assets that are indexed have pushed back on these claims. According to the article:

“Not surprisingly, the managers of index funds have thrown cold water on these possibilities, and on the empirical research itself. In March, BlackRock published a 24-page missive on common ownership, disputing much of the evidence and many of the claims. The analysis-echoed by other critics, including many academics—finds unconvincing, for instance, the airline paper’s claim that higher fares were ‘a direct result’ of the 2009 merger between BlackRock and Barclays Global Investors.”

What this theory does reinforce is the role that anti-trust laws play when it comes to a properly functioning market and it is not clear-cut. Like most things, it is messy and up for much debate. We need private market incentives such as patents and copyrights in order to motivate individuals or businesses to develop products and innovate. There must be some sort of private reward for putting in their effort and risking their capital. The flipside of this is the potential for a particular company to dominate the market and dictate prices for consumers. This is where competition plays a very important role. This tug-o-war between incentives and competition is what really matters and where civil debate should be engaged. Pointing the finger at index funds and playing the blame game is ultimately taking a complex issue and oversimplifying it. 

Index funds have provided investors with broad diversification and access to the capital markets at a much lower cost than their active fund counterparts. There is a difference between how managers are interpreting what is in their shareholders' best interests and shareholders actively engaging in corporate board decisions involving anti-competitive strategies. Current academic research has not provided robust evidence that the latter is actually happening. Concentration of wealth in any form is not good for the longevity of a healthy market and a healthy nation. The role of free markets needs to be balanced by proper engagement from the government. Defining the rules in which the markets can function is at the very heart of ensuring their efficacy.