Morningstar Magazine - December 2017/January 2018 - 18

Dispatches

Would Policymakers
Target Index
Funds? Concentrated
ownership debate
has found a receptive
audience among
politicians.
POLICY

Aron Szapiro

A small but growing body of provocative literature
has argued that when institutional investors own
large shares of competing companies, it results
in higher prices for consumers. This literature has
profound implications for policymakers looking
to promote competitive markets.
For example, Azar, Schmalz, and Tecu
(2017) conclude that the government should
restrict institutional investors from owning
competing firms if the anticompetitive effects
of common ownership are not outweighed
by the efficiency-enhancing effects of
diversification. Others have already suggested
policy responses to concentrated ownership,
most notably Posner, Morton, and Weyl
(2017), who would restrict asset managers
from owning more than one company in
a competitive industry.
This debate may seem academic, but it may find
a receptive audience among politicians,
at least among Democrats. With the release
of their Better Deal policy document, Democratic
politicians signaled they plan on running for
election in 2018 on a campaign of breaking up
unpopular monopolies (albeit without yet naming
large asset managers as a target).
As these ideas jump from economics and legal
literature to policymaking, policymakers will need

18

Morningstar December/January 2018

a framework for evaluating whether the potential
costs of concentrated ownership are, in fact,
greater than the benefits. As Azar et al. conclude,
"Which effect prevails is an empirical question
that goes beyond the scope of our paper,
which merely intends to start the debate." This
short column will not answer the question
of which effect prevails, either, but it seeks
to ascertain the key questions that policymakers
need to ask to develop a framework.
The Benefits of Index Funds

Dramatic changes could be required to eliminate
any anticompetitive effects of common ownership of competing companies. For example, Posner
et al. explore a few solutions before concluding
that an institutional investor should own
no more than one company in a potentially
uncompetitive industry unless the investor owns
less than 1% of the market share.
Further, the paper argues that no institutional
investor should communicate with top
managers or directors of such a firm. (According to
Posner et al., a potentially uncompetitive industry
is one where a few large companies do
not compete for market share. They call this
an oligopoly and define it using a mathematical formula for competition, although they
envision regulators would have discretion
to designate oligopolies.)
This novel approach has the potential to
dramatically change the operations of index funds;
it could fundamentally turn them into active
stock-pickers. After all, active funds constrained
from owning, say, multiple airline companies could
continue to use the tools of active ownership to
determine in which airline to invest. So,
the rule, while a constraint, does not alter the
value proposition of an active fund the way it does
a passive fund.
To quantify the costs of such a change,
policymakers first need to understand how many
people benefit from index funds. More than
50% of Americans have retirement savings
accounts. Changing one of the key innovations
in retirement investing over the past 30 years
directly affects 57 million households, according
to our analysis of the Survey of Consumer

Finances. In short, such a shift would not
only affect a small number of institutional investors
profiting from concentrated holdings in
leading companies but also many Americans
saving for retirement.
Another critical question is the importance
to investors of the diversification that common
ownership provides. Common ownership
is a necessary byproduct of diversifying in a single
fund. If a fund has the goal of providing
broad ownership of the stock market to achieve
diversification, it is necessarily going to hold
shares in competing companies. Posner
et al. cite Campbell, Lettau, Malkiel, and Xu (2001),
who argue that the volatility of not diversifying
across companies can be mitigated by diversifying
across industries. But how robust is this
finding over time? Presumably, some investors
will end up investing in the airline, bank, or
technology company that doesn't perform well
or is driven out of business by competitors.
Will this create a "longer tail" of failed retirement
accounts by increasing the idiosyncratic risk
retirement savers and other investors take on in
their investments? Indeed, Morningstar has found
that most returns earned by investors can
be attributed to the growth of the upper 20%
of successful companies-growth many investors
would miss if they were in funds forced
to choose among leading companies, rather
than owning several leaders in a broadly
diversified fund.
Posner et al. argue that passive funds could
randomly select companies within an industry and
that investors could hold multiple funds with
overlapping strategies to mitigate this problem.
But this would have large ramifications for
the retirement-plan market. Employers who offer
401(k) plans would have to offer new options
and explain to employees how to use them.
There also likely would be risks that such a novel
approach would violate fiduciary principles.
Further, asset managers would lose the economies
of scale that have led to steadily decreasing
costs for investors.
Which leads to another question: How broad
are the benefits of index funds beyond their
reduced costs for people who invest in them?



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

Contents
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Morningstar Magazine - December 2017/January 2018 - Cover2
Morningstar Magazine - December 2017/January 2018 - 1
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