Index funds have recently been the target of a peculiar attack. Its proponents argue that these funds, which implement a passive strategy to track the performance of an index, pose a serious threat to free competition.
What’s wrong with index funds?
Index funds, whether they are ETFs, mutual funds, or UCITS, try to closely replicate the performance of an index. In order to achieve that, they usually use ‘physical replication’, i.e. they purchase all the components of the index, with the appropriate weights.
This physical replication means that large funds tracking specific industries end up having large holdings in all the firms of that industry. That is where the problem originates: if there are few firms in an industry, and we are in an oligopolistic situation, then concentrated ownership may lead to milder competition than before.
Indeed, a fund manager who owns stakes in all the market participants probably won’t want to push these various firms to compete against one another. If the various firms of the industry were to compete for market share through a price war, then the market shares of each firm would be shuffled—however, the profits generated by the industry as a whole would decrease, negatively affecting the performance of the funds holding them.
Therefore, it is in the interest of the funds to let the firms collude—which can also happen in an unspoken, understood manner—to maintain the status quo or to raise prices, hurting consumers. For example, there is convincing evidence that common ownership in the US airline industry has pushed up plane ticket prices by up to 10%.[1]
Should we ban index funds?
The proponents of the antitrust critique do not go that far. Rather, they suggest implementing a “one firm or one percent” rule, which they formulate as follows: “No institutional investor or individual holding shares of more than a single effective firm in an oligopoly may ultimately own more than 1% of the market share unless the entity holding shares is a free-standing index fund that commits to being purely passive.”[2] Laws in Europe already prohibit UCITS funds from building up controlling stakes in any security issuer.[3] But this proposed rule is much more complex and problematic.
First of all, the limits are not to be applied at the fund level, but at the investment company level. It would indeed be easy to create an umbrella fund, under which each of the funds individually would abide by this rule, but in aggregate they could break it. There is a problem, however: an investment company providing purely passive funds (ETFs and such) alongside active funds would be barred from investing in certain industries. Hence, the concerned investment companies would have to make a choice about which funds—and thus which investors—to favor, leading to an unhealthy discrimination of investors.
If funds decide to cope with the 1% hurdle by taking the other choice offered to them, i.e. by investing in a single entity, it would have two detrimental effects simultaneously: it would transform the passive index trackers into active funds selecting a sample of firms to invest in, and it would decrease their diversification and hence decrease the correlation with the index they try to track.
We could also mention that choosing the measurements and thresholds to identify oligopolistic industries is tricky. The proponents of the critique[4] suggest using a MHHI or GHHI, which are modified versions of the Herfindahl-Hirschman (HH) concentration index taking into account common ownership. Notwithstanding the thresholds attached to these exotic measures, their effectiveness is debatable, and their use by academics is very limited.
But let’s put things into perspective: the proposed rule claims to limit the bad effects of common ownership. However, the incentive for the firms to not compete with one another doesn’t need to materialize in the form of explicit pressure: the fund managers do not need to remind the firms that they are looking to maximize the return of their whole portfolio and not only of a single specific firm. In short, the proposed “one firm or one percent” rule would both fail to eliminate the source of the anticompetitive behaviors observed, and cause serious threats to index tracking funds.
So… laissez-faire
Laissez-faire would mean accepting the cost of the pseudo cartels and letting the funds invest as much as they want in oligopolistic industries. It would be acceptable to do so if the cost of the oligopoly to the consumer is, in aggregate, lower than the benefits for investors. Typically, however, this is not the case, as any oligopolistic or monopolistic behaviors incur a “deadweight loss” of utility for all players in the market.[5] Therefore we must tackle the competition problem posed by common ownership.
Limiting barriers to entry is an efficient way to incentivize oligopolies to compete with one another. Indeed, if new competitors may enter the market at any time, oligopolies have an interest in not creating the conditions for super-profits which would doubtlessly attract new competitors. We call such markets ‘contestable markets.’[6] Often the State has the power to limit barriers to entry: making licenses more readily available and administrative and legal procedures shorter, easier and less costly can encourage national entrepreneurs to join the industry and disrupt anticompetitive behaviors. That Xavier Niel’s Free Mobile in France received a mobile operator license to in 2010 shows how decreasing barriers to entry can break up oligopolies.
The state can also limit barriers to entry by lowering customs as well as other barriers to foreign companies. That is actually how Ryanair successfully started in 1986: they took advantage of new EU regulations to compete with legacy carriers in Ireland and in the UK.
Another approach to pushing oligopolistic firms to compete with one another is to welcome the efforts of activist shareholders. These investors often receive bad press, but they actually have, in the aggregate, positive effects on the firms in which they invest.[7] Activist investors could provide the necessary incentive to a firm to exit the de facto cartel and compete on prices with the other firms of the industry. They would have a first-mover advantage, and thus give a superior return to the activist investor, generating a positive effect for the consumers.
Summing it up
The antitrust critique argues very sensibly that index tracking funds provide a damaging incentive on oligopolistic industries to soften competition and adopt cartel behaviors. This is a concerning issue that deserves more attention from the industry, from academics, and from regulators.
However, we must be very cautious when trying to solve the problem: in principle, index trackers are good and provide useful solutions for investors. We should aim at finding a way to solve the problem without harming these funds.
Targeting oligopolies and trying to counterweight the influence of index trackers thus seems to be the most sensible solution to the problem. The role of the State shouldn’t be to close opportunities, but to open new ones: instead of preventing funds from operating through complex rules, the State should eliminate regulatory barriers, and foster competition and innovation in oligopolistic industries.
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[1] José Azar, Martin C. Schmalz, and Isabel Tecu, “Anti-Competitive Effects of Common Ownership”, 2014
[2] Eric A. Posner, Fiona Scott Morton, and E. Glen Weyl, “A Proposal to Limit the Anti-Competitive Power of Institutional Investors”, 2017
[3] Law of 17 December 2010, Article 48 (1)
[4] José Azar, Sahil Raina, and Martin C. Schmalz, “Ultimate Ownership and Bank Competition”, 2016
[5] Arnold C. Harberger, “Monopoly and resource allocation”, The American Economic Review, 1954
[6] William Baumol, John Panzar, Robert Willig, Contestable Markets and the Theory of Industry Structure, 1982
[7]The Economist argues that activist investors shake up management out of their comfort zone for the benefit of existing shareholders, the firm itself and the customers: http://www.economist.com/news/leaders/21642169-why-activist-investors-are-good-public-company-capitalisms-unlikely-heroes
