Morningstar Magazine - December 2017/January 2018 - 36

Spotlight: Abnormal Profitability

to have costs and benefits. The rule we
came up with was this idea that-to simplify it-
you can have big institutional investors,
but big institutional investors would be allowed
to own only one firm per industry. Or you
can have small institutional investors who could
be fully diversified; they can own all the firms
in one industry, but they just have to have less
than a 1% [market] share.
If our rule were put into place, we would predict
that the market would segment, and you
would see the big institutions like BlackRock divest
from all the firms in a concentrated industry
except for one and increase the stake in that
remaining firm. BlackRock might have, say,
10% of United and 0% in the other airlines. In the
meantime, you could see lots of smaller asset
managers who could have 1% in all the airlines.
That's the idea. Now, it's easy to poke holes in this
solution because by design it's simple.

companies I've never heard of and that maybe
I'd be nervous about giving them my money.
Or I could stick with Vanguard. I would just
be slightly less diversified. Our initial view was that
the cost would be low because the amount of
diversification an ordinary person gets by owning
all the companies within one industry as
opposed to companies across industries is very
small, because the stock prices of companies
within an industry tend to be highly correlated.
If I am just an ordinary person and I want
to be fully exposed to the stock market, there is not
a whole lot of difference between owning stock
in one company per industry as opposed to owning
stock in every single company in the market.
That's why the S&P 500 is probably fine for most
people. They don't really need to own
stock of 2,000 companies or 10,000 companies.
So, mathematically, the additional diversification
benefit you get is small.

In your paper, you make a fair amount of a study from
Campbell et al. that argues you can achieve diversification by investing across industries.4 But no matter
what the strategy is for diversifying across
industries, if you're only holding one company in each
competitive industry, some investors would end
up worse off. Wouldn't you create a long tail of bad
outcomes for, say, the person who ended
up holding Pan Am in the mid-1980s instead of
United Airlines?

So, either the lost diversification or, as I noted
earlier, the cost of diversifying by contracting with
small asset managers is the price of our rule.
We think that the costs are less than the benefits.
There are, for example, very high airline ticket
prices relative to what you would have otherwise.
If I were in Congress, I wouldn't necessarily
implement our rule tomorrow, but we would like
to get some debate about it going.

Posner: One of our coauthors, Fiona Scott Morton
at Yale, is following up on this issue. She is
doing an empirical analysis of this diversification
question. She is doing simulations involving
different portfolios to see how much you lose-
how costly it is for people to lose this additional
amount of diversification. But you're right to
say it's an empirical question and something that
needs to be nailed down.

Looking at the ownership stakes of Vanguard and
BlackRock today, it's already approaching 6%
to 7% of each company. If they were to concentrate
in one company and if their market share
continues to grow, you could imagine a case where
Vanguard owns a majority or close to a majority
of one competitor and BlackRock owns close to a
majority stake in another competitor, which seems to
bring a whole host of other questions into play.

One problem is that people would have to
search out and find the small [asset managers]-
the 1% companies-if they want to be fully
diversified. I know who Vanguard is. I know who
BlackRock is. But there are a lot of financial

Posner: Right. This could happen, or it might not
happen because BlackRock or Vanguard
might divide. They might become smaller. But yes,
it could happen. And then the question is,
would this be a bad thing? There are different
theories about this. This is not uncommon

in other countries, places like Korea and Japan,
where these [concentrated] ownership
structures prevail. The worry would be that the
institutional investors might collude with
each other and cause their underlying firms not
to compete. They might have a stronger incentive
to do that. Of course, that will remain illegal.
It would be a new world that would have to be
addressed. I don't see any reason in theory to think
that it would be worse, but we wouldn't know
for sure until we entered that world. A lot would
depend on what they [firms like Vanguard
and BlackRock] did. If they continued to be passive,
as they claim they are now, there wouldn't
be any anticompetitive effect. The smaller, more
active owners would presumably not be as
diversified and would presumably try to get the
CEOs of these companies to compete more. That
would be fine. Then, it wouldn't matter if
BlackRock owned half a company.
But there would be complicated governance
issues that would arise. As a legal matter,
they might have more responsibility. So yes, I can
see issues coming up. It would be good to
see somebody do a rigorous analysis of this based
on comparative work, looking at how this
looks in other countries. But at the moment, I'm
not worried about this.
Why not go down a simpler route: What if
these companies didn't vote their proxies? What is the
argument against that approach?

Posner: A lot of people have suggested that,
and I think that's an appealing approach.

My worry would still be that CEOs would
be less willing to compete simply because they
know that their big owners do better if
they don't compete. That's the big problem, which
is not solved by limiting the voice of the
institutional investors.
Somebody has to fire the CEOs, control the CEOs
in some way. And if the CEOs think that the
institutional investors will support them, even

4 Campbell, J.Y., Lettau, M., Malkiel, B.G., & Xu, Y. 2001. "Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk," The Journal of Finance, Vol. 56, No. 1,
February, pp. 1-43.

36

Morningstar December/January 2018



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