Alumni economists debate common ownership

When John Bogle ’51 created the first index mutual fund in 1976 — based on an idea he hinted at in his Princeton senior thesis — it was ridiculed as “un-American.” After all, passively managed index funds don’t even try to beat the market like traditional stock pickers do. Instead, index-fund managers buy and hold all the securities in the market and are content to settle for average returns.

Twenty years later, amid the late ’90s bull market, conventional wisdom changed and indexing was hailed as a great democratizing force on Wall Street, allowing investors big and small to instantly diversify their money for a fraction of the cost of traditional funds.

Fast-forward another 20 years, and opinions could be shifting again. A small but growing group of economists now say index funds may be anti-capitalist because they stifle competition in the broader economy.

How could an investment that’s made millions of people rich while funneling trillions of dollars of capital into private-sector firms be anti-capitalist?

Index-fund managers don’t pick the stocks they own — the funds mirror a market benchmark. For instance, the Vanguard 500 — the first passive fund Bogle brought to market more than 40 years ago — tracks the S&P 500 index of American blue-chip companies. As a result, the fund owns shares of all 500 of the largest publicly traded companies in the country, including every major airline, automaker, drugmaker, steelmaker, retailer, etc.

John Bogle ’51, Vanguard founder: “I don’t want my life’s work destroyed — least of all because it works.”
Peter Foley/Bloomberg via Getty Images
No one disputes that this hyper-diversification has benefited fund investors by reducing risk while driving down costs (index funds don’t require teams of research analysts and stock pickers). But could this overlapping ownership structure — in which rival companies within the same industry are owned by the same set of funds — discourage ruthless competition?

This potential problem, known as “common ownership,” was first explored in 1984 by economist Julio Rotemberg *81, who worried that companies might “tend to act collusively when their shareholders have diversified portfolios.” 

Back then indexing was an obscure strategy barely attracting any assets, and Rotemberg was just starting out. (He died in April after a distinguished career at Harvard Business School.) But virtually every new dollar that’s gone into the fund industry in the past three years has been put into passively managed products. So common ownership is getting another look.

José Azar *12, an assistant professor of economics at the University of Navarra’s IESE Business School in Spain, points out that two of the largest managers of index funds in the U.S., BlackRock and Vanguard, control a sizable portion of virtually every major company in the market.

“BlackRock has $6 trillion in assets and Vanguard controls close to $5 trillion,” he says, and that will naturally lead to overlapping ownership of the same names in the same industries. “We’re not saying indexing is the only cause,” says Azar, noting that some of the assets controlled by these firms are held in traditional, actively managed portfolios. “But it’s clearly one of the biggest.” 

Economist José Azar *12: “We’re not saying that indexing is the only cause. But it’s clearly one of the biggest.”
Edu Ferrer
Azar began studying how ownership structure affects corporate behavior as part of his dissertation. “I was looking at the auto industry and issues such as fuel economy. But that’s when I started looking at the companies’ shareholders.” He continued exploring the unintended consequences of common ownership after graduation, with fellow economists Isabel Tecu and Martin Schmalz *12, now an assistant professor of finance at the University of Michigan’s Ross School of Business.

Their study, “Anti-Competitive Effects of Common Ownership,” looked at the high degree of cross-ownership among the nation’s major airlines. Their research determined that “ticket prices are approximately 3 to 7 percent higher on the average U.S. airline route than would be the case under separate ownership.”

A separate study found that common ownership also has an effect in the banking industry, leading to higher fees on deposit accounts and lower interest rates on savings accounts. Still another study blames this trend for runaway CEO pay.

Bogle isn’t buying it. “Is it credible to think that mutual funds are actually conspiring in this manner? That’s absurd.”

He adds that while this may be “a fascinating argument on an academic level, I’m dealing with the real world.” And, he says, “there’s absolutely not a scintilla of evidence” that fund companies are colluding to get rival corporations to cooperate more or compete less.

Bogle isn’t the only skeptic.

“It’s an interesting and sexy topic,” says Todd Gormley, associate professor of finance at the Olin Business School at Washington University in St. Louis. But “I’m not convinced by that literature.”

He points to a problem in the logic. “Index funds don’t just own all the companies in one industry, they own every industry,” he says. “Let’s assume that airlines are raising prices or banks are raising fees to appease their index-fund owners. But air travel and banking are input costs for every other industry. Isn’t that hurting all the other companies in their portfolio?”

What’s more, Gormley says, it’s difficult to think how an index fund would try to convince a management team to be less competitive.

Schmalz contends that owners don’t have to meet in a smoke-filled room for competition to be stifled. Simply knowing that your largest shareholders are also the owners of your competitors may be enough to sway management to hold back some of their punches, he says.

“In a world where Richard Branson owns Virgin Atlantic and I control Delta and you control United, each of us would be telling management to steal market share from the others,” Schmalz says. In this case, he goes on to ask, where is the evidence of index-fund managers encouraging companies they own to be that competitive?

Gormley says there is evidence of some positive effects of passive ownership. A study he co-authored found that corporations owned largely by index funds exhibited better governance — for instance, by having more independent directors and more equal voting rights.

Glen Weyl ’07 *08, research scholar at Yale, believes that the interests of workers and consumers have to be considered in addition to the interests of investors.
John Brecher

Some legal scholars believe big companies that run index funds may already be in violation of antitrust laws, which ban any stock acquisition that “substantially lessens competition.” But Glen Weyl ’07 *08, a senior visiting research scholar in economics and law at Yale, says that applying those laws on a case-by-case basis could be chaotic and disruptive to an industry that many Americans rely on for their retirement savings. 

Instead, Weyl and two of his colleagues have proposed a different solution. 

They are calling for restrictions on the ability of asset managers like BlackRock or Vanguard to own large chunks of companies officially designated as oligopolies, where only a handful of firms dominate: Funds could either own more than 1 percent of a company if they agree to invest in just one firm per industry, or they must cap their holdings to less than 1 percent of each company.

To Bogle, this would be untenable.

“There are something like 124 different industries. That would mean a minimum of 124 divestitures in index funds,” Bogle says. “If there was a forced divestiture by index funds of all these extra companies, how many hundreds of billions of dollars of taxable capital gains would be inflicted on shareholders?”

What’s more, under such a rule, major index-fund providers would have to go against the tenets of indexing by picking and choosing one stock over another. “You’d have a situation where in tech, Vanguard would have to choose, say, Google, while BlackRock says we’re going with Facebook and State Street saying we’re going with Apple,” he says. 

“That’s active management,” Bogle says, adding: “I don’t want my life’s work destroyed — least of all because it works.”

Weyl, who describes Bogle as a hero, says he understands Bogle’s concerns, but believes that the interests of workers and consumers have to be considered in addition to the interests of investors.

Thanks to the proliferation of index funds in 401(k) retirement plans, however, many of those workers are also investors — another twist in this very complicated issue.