Morningstar Magazine - December 2017/January 2018 - 10

Dispatches

Why might this be a problem? Imagine the extreme
case in which a single shareholder gained
control of a majority stake in all three firms. The
incentives of that owner are clear: Maximize
the collective value of these three companies,
rather than any single one. Such an owner
wouldn't want Pfizer, Merck, and J&J all pouring
billions of dollars into R&D focused on the
same disease. Better to have each company focus
in separate areas, charge higher prices, and earn
higher overall returns on capital. In such a
world, you'll see companies migrate toward the
northwest quadrant of the famous prisoner's
dilemma chart.

Cooperate

Oligopoly

Firm A Flourishes
Firm B Struggles

Firm B Flourishes
Firm A Struggles

Competition

Firm B

Compete

Compete

Firm A
Cooperate

It's counterintuitive to think that passive
shareholders like Vanguard could be playing the
role of cigar-chomping robber baron pushing
firms into oligopolistic behavior. But, some argue,
even passive investors vote proxies, engage
with management teams, and influence
management compensation. Ironically, it was
in part to counter criticism that passive
investing lets management teams off easy that
companies like Vanguard emphasize their
level of corporate engagement. Vanguard is quite
explicit on how active it is in lobbying for
executive compensation packages that align
the interests of managers with their own;
emphasizing returns on capital; voting on mergers;
and making sustainability a factor in the way
it votes proxies.

The barbarians' underlying logic is undeniable.
There is an incentive for companies controlled
by the same owners to not compete as
fiercely as they otherwise would. The question
is whether the degree of common ownership as
exists today is truly significant enough to
influence the way companies are run. The
barbarians argue that we're starting to see this.
Spearheaded in part by José Azar, an economist
at IESE Business School, and Eric Posner,
a law professor at the University of Chicago, a
group of academics argues that there's empirical
evidence of such behavior in two industries
in particular: airlines and banking.1 Another paper
on the same topic concludes by claiming that
"the combination of large-shareholder
diversification and imperfect competition has
a profound impact on the structure of top
management incentives."2
We think the jury is still out. The effects the
authors are trying to tease out of the data are
subtle, making it difficult to prove anything
definitive given the model assumptions and data
challenges involved. For example, the
industries with the most concentrated ownership
will tend to be those concentrated in the first
place, as passive owners tend to own a greater
portion of large companies than they do
of small companies. (Think of index funds that
track the S&P 500; by definition, they don't own
companies outside the 500 largest.) Or the
distorting effects of the choice more companies
are making to stay private, which has caused
a significant decline in the number of U.S. publicly
listed companies (thus keeping them out of
the portfolios of index funds). Even assuming there
is an impact on profitability, we think it pales
in comparison with the other trends we've
discussed-the benevolent macro environment,
the changing constitution of the market's leading
firms, and the rise of institutional ownership
in general over multiple decades.
But perhaps more pertinent is the cost/benefit
analysis of any policy corrective. The benefits
of this implicit collusion-if it exists-are not

a small group of fat-cat capitalists. It's hundreds
of millions of investors worldwide who
have invested in index funds and other lowcost vehicles-vehicles that have done far more
good than harm for investors and society
overall. If policymakers act rashly, they could
create disincentives to invest in some of
the best investment options available. As Aron
Szapiro discusses in this issue (Page 18),
some policy proposals risk doing just this.
An Issue That Won't Go Away

Vanguard and BlackRock would like nothing
more than for this issue to go away. But regardless
of what you think of the barbarians' argument,
it's hard to see how it will. Today, passive
makes up close to 40% of assets in U.S. equity
funds and rising. We believe the trends favoring
low-cost, rules-based investments are firmly
in place, so we expect those percentages to only
increase. It's within the realm of possibility
that Vanguard and BlackRock could own
a combined quarter of every major U.S. company
between them. While such concentration isn't
unheard of-think Japan with its keiretsu, China's
state-owned enterprises, or Europe with its
history of bank shareholdings and nationalization
of strategic industries-for the U.S. this is
uncharted territory. If enough academic research
demonstrates a connection, however tenuous,
between these high ownership stakes and
increased profitability, look out. All it takes
is for one populist politician or ambitious regulator
to transform this into a headline policy issue.
That's why we're highlighting the topic in
this issue. We're skeptical that concentrated
ownership is having a material impact
on corporate behavior, but we expect it to remain
a hotly debated topic for years to come.
Whether you like it or not, the barbarians aren't
going away. K
Haywood Kelly is head of global research with
Morningstar. He is a member of the editorial board
of Morningstar magazine.

1 See, for example, Azar, J., Schmalz, M., & Tecu, I. 2017. "Anti-Competitive Effects of Common Ownership," Journal of Finance, forthcoming.
2 Anton, M., Ederer, F., Gine, M., & Schmalz, M. 2017. "Common Ownership, Competition, and Top Management Incentives," Annual Review of Financial Economics, forthcoming.

10

Morningstar December/January 2018



Table of Contents for the Digital Edition of Morningstar Magazine - December 2017/January 2018

Contents
Morningstar Magazine - December 2017/January 2018 - Cover1
Morningstar Magazine - December 2017/January 2018 - Cover2
Morningstar Magazine - December 2017/January 2018 - 1
Morningstar Magazine - December 2017/January 2018 - 2
Morningstar Magazine - December 2017/January 2018 - Contents
Morningstar Magazine - December 2017/January 2018 - 4
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