Morningstar Magazine - December 2017/January 2018 - 14

Dispatches

Index-Fund Imbroglio
Regulate CEOs,
not asset managers.

Not only were those arguments weak, and thus
largely ignored by the shareholders they targeted,
they also remained outside the courtroom.
Nobody filed lawsuits against indexers or sought
regulatory changes. The battle between the
incumbent investment managers and the upstart
indexers was waged in the business world.
To the victor went the spoils.

IVORY TOWERS

John Rekenthaler

This issue of Morningstar magazine contains two
articles, besides this one, that consider the
possibility that the growth of index investing has
contributed to corporations' abnormal profitability. In "Do Vanguard and BlackRock
Own Too Much of Corporate America?" (Page 34),
the University of Chicago's Eric Posner
answers, "Yes." Morningstar's director of policy
research, Aron Szapiro, then considers legislative
remedies in "Would Policymakers Target
Index Funds?" (Page 18). Ideally, readers will
proceed in that order: Posner first, to establish the
case; then Szapiro, to understand the possible
Washington responses; then, finally, this article,
which complements the other two.

There is a new critic in town, however. This
one has greater credibility than the self-interested
active managers. That critic is the academic
community-the very community, of course, that
fostered the very notion of the index fund
and that, until now, has been such an enthusiastic
supporter. The parents have turned on their child.
Is Competition Insufficient?

A recent paper, "Anti-Competitive Effects
of Common Ownership," by José Azar, Martin
Schmalz, and Isabel Tecu, gives the thesis.1
Indexers harm society. Index funds, they say,
encourage CEOs to behave as semimonopolists,
while overpaying themselves.
That paper has quickly attracted attention, being
the right paper for the right time. The United
States currently offers two major economic puzzles:

From Industry to Academia

The claim that index fund managers-or, more
generally, any institution that invests so widely as
to hold multiple stocks across the nation's
industries-are soft on corporate CEOs is,
of course, scarcely the first charge to be levied
against indexers. Traditional investment
managers have disliked index funds ever since
they were introduced.
Indexing's competitive threat has sparked 40 years
of attacks from active managers. Buying an
index fund, they state, means settling for
mediocrity. Index funds are losers, because after
expenses they trail their benchmarks. Indexing
creates stock-market bubbles, because index funds
invest mindlessly, without regard for valuations.
Indexing distorts security prices, inflating the
prices of stocks held by the major indexes, while
depressing those of the outsiders.

1 Why have almost 10 years of low interest rates (and

Morningstar December/January 2018

Note that the academic strike against indexing
is more profound than the assaults by active
managers. The latter merely suggest that indexing
disrupts the functions of the stock market.
The academics, on the other hand, suggest that
indexing has helped create fundamental
social problems, such as rising income inequality
and overly high prices paid by consumers.
Counterpoints

It's worth noting that while this hypothesis
has attracted much academic attention,
and is now starting to appear in Washington policy
discussions, it hasn't yet convinced many
investment professionals. The argument
is circumstantial; it consists of regressions that
show correlation, without demonstrating the
reasons for those relationships. The authors have
one explanation, but others are certainly possible.

quantitative easing) not triggered inflation?
2 Why do U.S. corporate profit margins set new highs

each year?
The authors answer the second of those two
great questions.
The paper's thesis: In large part, profit margins
have become elevated because a handful of huge
index fund providers own everything. All the
major U.S. companies. Such "common ownership,"
as the authors term it, discourages competition.
Index funds don't want CEOs to compete, because
one company's gain becomes another's loss. They
want CEOs to coexist peacefully, by implicitly (if
not explicitly) colluding so that their prices remain
high, and the wages they pay to labor are low.

1 Azar, J., Schmalz, M., & Tecu, I. 2017. "Anti-Competitive Effects of Common Ownership." Journal of Finance, forthcoming.

14

This is how Posner states the matter: "When
institutional investors started buying up
large chunks of [corporate America], 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."

Indeed, many researchers account for abnormal
corporate profitability with other explanations. The
decline of organized labor and of the national
minimum wage (if inflation-adjusted), along with
increased automation, has reduced many
companies' costs. According to Morningstar's
research, industry characteristics have also
changed, such that more companies now boast
wide moats that support margin expansion.
("More Moats, More Profits," Page 29.)
The case against common ownership (and
thus index funds) will require considerably more
evidence to be proved. For the purposes
of discussion, however, let's assume the case has
been won and evaluate some proposals for
redressing abnormally high corporate profitability.



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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