Should Mutual Funds Be Illegal?
I wrote yesterday about what I think is a congealing regulatory view that index funds are Good and should be encouraged, and that active management is Bad and should be discouraged, but here is a wonderful mad corrective from Eric Posner and E. Glen Weyl at Slate, calling on Congress to ban index funds:
Another approach would be for Congress to pass a law that restricts the holdings of mutual funds and other institutional investors. The law would be very simple. Currently, employees and employers get tax advantages when employers set up retirement accounts for employees. The government regulates the types of funds that employers may offer to their employees. The government should direct employers to offer only mutual funds that do not own a significant number of shares of more than one firm in a specific industry. In other words, mutual funds would be allowed to own shares of only a single firm in any specific industry, but could invest in as many industries as they wanted.
So it's not just index funds; diversified actively managed funds would also face restrictions, though "By owning shares in different industries, mutual funds could continue to offer the diversification benefits that investors value them for." Index funds, though, which by definition own all the companies in all the industries, 1 would be off limits in this regime, at least in retirement accounts. 2
So ... why? Posner and Weyl are riffing on this paper by José Azar, Martin C. Schmalz and Isabel Tecu, finding, according to its title, "Anti-Competitive Effects of Common Ownership." Azar, Schmalz and Tecu look at the airline industry, where a good percentage of the shares of many big airlines are owned by overlapping groups of big mutual funds (not necessarily index funds). They argue that this common ownership reduces competition, finding "that ticket prices are approximately 3-5% higher on the average US airline route than would be the case under separate ownership." A possible explanation for this finding is that mutual funds that own lots of shares in all of the airlines don't really push any one airline to cut prices to compete hard against the other airlines: Cutting margins to gain market share might work for one airline, but for the airlines as a group it drives down profits. And airlines' shareholders own airlines as a group, not individually.
This doesn't necessarily need to be an explicit conspiracy. Azar, Schmalz and Tecu:
A more benign – and likely – interpretation of our results is that owners generally need to push their firms to aggressively compete, because managers will otherwise enjoy a “quiet life” (Bertrand and Mullainathan, 2003) with little competition and high margins. Only shareholders with undiversified portfolios have an incentive to engage to that effect, while only large shareholders have enough clout to do so. However, the largest shareholders of most firms tend to have diversified portfolios and therefore reduced incentives to push for more competition, whereas smaller undiversified investors don’t have the power to change firm policy without the support of their larger peers. It is important to realize again that it is both unlikely and unnecessary that shareholders give their portfolio firms explicit directions with respect to the desired intensity of competition in particular markets.
Diversified investors are less likely to push for price wars than those whose fortunes are tied to a single competitor, and managers are less likely to start price wars if they're not pushed.
Going from that conclusion to banning diversified mutual funds is a bit of a stretch. I tweeted about Posner and Weyl's article and the reactions were, I think it is fair to say, uniformly incredulous. Josh Barro pointed out that "airlines seem like a bad example of anticompetitive pricing, since they go bankrupt all the time." More generally, people seemed horrified by the argument that the government should try to limit indexing and diversification.
I mean, as was I! Still, I want to mount a couple of tepid partial defenses. First, Posner and Weyl come to the question from a quasi-Pikettian standpoint. Index funds are a darling of regulators and commentators because they seem like a victory of the common man over Wall Street scheming: Index funds are available to everyone, cheaper than Wall Street's preferred complex financial products and tend to perform better. But Posner and Weyl explicitly concede that restrictions on mutual fund diversification will hurt investors; they just argue that the benefits to consumers from more vigorous competition will outweigh those losses:
By reducing the monopolization of markets, it should lower prices for everyone. The returns to investors would decline, but their losses would be much less than the gains to society from the price reductions.
This strikes me as an empirical point with ... not much evidence? I have a lot more at stake financially in my retirement accounts than I do in my occasional airline flights, and even if you believe that Posner and Weyl's proposal would cut airline prices by 5 percent it seems dangerous to extrapolate that to other industries. 3 But, I mean, it's a coherent point of view: You could think that diversified mutual funds are great and help average investors, while still thinking that they discourage competition and ultimately hurt consumers. You'd probably want more evidence, of course, but it doesn't strike me as a priori nuts.
Second, though, it's worth abstracting away from the specific arguments here to a more general point, which is that a lot of the way we traditionally think about corporate governance does not fully account for the fact that most investors are diversified. This comes up a lot in mergers and acquisitions. Company A wants to buy Company B. If they combine, they will have cost savings worth $X, and the question is how much of $X goes to Company B shareholders in the form of merger premium and how much of it goes to Company A shareholders. 4 If you are a diversified investor holding a proportional amount of both companies' shares, you don't care at all. You just want the deal done. But because corporate law, at least in the M&A context, gives directors a duty to maximize value for their shareholders, Company B will negotiate hard to get as much of the premium as possible. Money will be spent on bankers and lawyers. Company A might be pushed to raise a lot of debt to pay more, making the benefits of the deal riskier (for Company A). And Company B might ultimately just say no to a deal because it doesn't like how the benefits are split, denying those benefits to diversified shareholders. By maximizing value for its shareholders, considered as its shareholders, Company B might actually be hurting those same shareholders, considering their entire portfolios. 5
Most of the time when I think about these questions I wonder if companies give too little consideration to their shareholders' diversification. Investors -- especially the big institutional funds managing the money of retirees and other average investors -- tend to be diversified, but managers tend not to be. Most chief executive officers own a lot of shares of their own companies, and none of their competitors. 6 So you might worry that they have incentives to be provincial, favoring their own company's share price in ways that are inefficient for the diversified investors who actually own those shares. One intriguing result of this research is that that might not be true: Managers mostly own shares of their own companies, but their biggest investors are diversified, and now there's some evidence that their diversification has some effect on the managers' decisions. That influence might well be good for investors as a whole. And, who knows, it might even be bad for competition.
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Inexact: They own all the companies that are in the index; how many that actually is depends on the index. But you know what I mean.
You can't really ban index funds; people can just buy a lot of stocks. But you can limit them as a retail product: Posner and Weyl call for banning them from tax-advantaged accounts, but I guess nothing would stop Congress from banning them from registered '40 Act funds and limiting them to accredited investors.
Being me, I am of course interested in evasions. Like, you could have Sub-Index Fund A which owns the first S&P 500 company (alphabetically) in each industry, Sub-Index Fund B which owns the second, etc., and then investors would just have to allocate appropriately to each of the Sub-Index Funds. The weird thing is that Posner and Weyl's focus seems to be on fund companies, not individual funds, and I guess it makes sense that fund companies would make decisions together for multiple funds. So you'd need Vanguard to offer Sub-Index Fund A, BlackRock Fund B, etc., and it'd get weird.
Posner and Weyl are also making a distributive argument -- investors in aggregate are richer than consumers in aggregate, so cutting prices at the cost of investment returns would be progressive -- but don't discuss the effect on employment; competition can be good for consumers while also being rough on workers. Maybe more competitive airlines would buy all their planes from China rather than from Boeing, etc. That "quiet life" isn't just for executives.
In the form of, you know, not merger premium.
This argument is attenuated in stock-for-stock deals, though it doesn't disappear entirely.
Or take a more ambiguous case: Company A has some patents; Company B might or might not be violating them; should Company A sue? The case for suing will be stronger if you're just thinking about Company A shareholders as Company A shareholders than if you're thinking about them based on their actual diversified portfolio. Oh and by the way is that decision to sue or not to sue a question of "competition," like the price-war thing is?
I mean I imagine most of them also have some money in diversified mutual funds, but it would be weird for them to own shares in a competitor directly.
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