Index Funds May Work a Little Too Well
I have a good laugh every now and then about the people who think that index funds should be illegal because they make companies less competitive, but honestly it's a nervous sort of laughter. Those people are up to something, something so big and interesting that it makes them nervous too. Take Einer Elhauge, the Harvard Law School professor whose paper -- arguing that "stock acquisitions that create such anticompetitive horizontal shareholdings are illegal under current antitrust law" -- I discussed yesterday. Elhauge claims to disagree with my interpretation of his paper to mean that index funds are already illegal 1 :
Contrary to the claims of some, none of this means that index funds are inherently illegal under antitrust law. First, as I have stressed, institutional investor holdings are likely to be anticompetitive only when the holdings are in a concentrated product market (an HHI > 2500, or roughly four or fewer major firms) and substantial horizontal shareholdings exist (the same institutional investors have large enough holdings in the same competitors to make ΔHHI > 200). Second, while institutional investors as a whole hold 80% of S&P 500 corporate stock, only about 22% of institutional investor stock is indexed. Thus, if non-indexed funds divested their stock in some competitors in concentrated markets where substantial horizontal shareholdings exist, that would likely eliminate the problem in those markets. Third, funds could index investments across industries without doing so across each firm in each industry, and achieve nearly the same diversification benefits. Fourth, if index funds alone would create a problem of anticompetitive horizontal shareholding in a concentrated market, and those index funds feel the benefits of diversification across all firms in that market exceed the benefits of influencing corporate governance, they could commit not to communicate with management or vote their shares.
If you run an index fund, none of these responses should offer much comfort. Notice that Elhauge says index funds aren't inherently illegal, but not that they're not actually illegal. He thinks index funds would be legal with a few tweaks, but as of right now they're illegal.
But also the tweaks are not really plausible. Elhauge says that holding shares of multiple companies in the same industry is illegal only if that industry is a concentrated market, like, say, airlines. But it is hard for a passive investor to know in advance how antitrust regulators and courts will define a market, and anyway plenty of companies in the big indexes are in concentrated industries. 2 He says that indexers will be safe from antitrust concerns if other institutional managers stop buying multiple companies in a sector. But there's no particular reason to expect that -- diversification is good! -- and in any case it makes indexing fact-specific and uncertain rather than rule-based and predictable: You can't plan to buy all the stocks in the S&P 500, since some of them may be off-limits due to the constantly changing holdings of other investors. And he says that indexers are safe if they just pick one favorite stock in each industry, but that is of course not indexing. 3
His fourth response is the interesting one: You can index, as long as you don't vote. Remember that the theory -- explained most forcefully by Eric Posner and E. Glen Weyl in Slate, based on this paper by José Azar, Martin C. Schmalz and Isabel Tecu -- is that investors (index funds, diversified mutual funds, whatever) who own shares in multiple companies in the same industry cause those companies to compete with each other less vigorously. These investors want to maximize the profits of the industry, not the individual firm, and fierce competition is not in their interests. So -- the theory goes -- managers increasingly manage in the interests of those investors, leading to less competition, higher prices for consumers and a host of other problems. Posner and Weyl blame institutional investors for income inequality. Elhauge blames them for runaway executive pay, and for the rise in corporate profits unaccompanied by economic growth and investment. 4
None of this has much to do with voting. Shareholder voting just isn't very important; it's not like shareholders get to vote on airline ticket prices or route decisions. 5 If you think that institutional investors are causing managers to stop competing, there are more plausible mechanisms for that than voting. 6 Just leaving managers alone, for instance, probably itself tends toward anti-competitiveness: If shareholders don't pester management, they will probably compete less hard, just because that is easier. 7 "Voting with their feet" is another: If shareholders invest indifferently in both the best and the fourth-best firm in an industry, that will keep up the fourth-best firm's stock price and lower the best's, reducing incentives to be the best. Or there is just fiduciary duty: Managers may want to do what's in their shareholders' best interests because that is what they are supposed to be doing. 8 Even if the shareholders don't actively force them to.
Now Elhauge is a law professor making a legal point, and legally, it might matter whether diversified investors actively seek to influence managers by talking to them or voting on their compensation. 9 But if you are concerned, not with the narrow question of whether index funds are illegal, but rather the broader question of whether they should be, this is not very satisfying. If you think that the rise of diversified institutional investing is a bad thing, then you will want to go beyond those investors' voting records on executive pay.
Because this is not about how they vote, or even really about who owns airline shares. Rather it is about how companies think about their shareholders, and their fiduciary duties. Should companies be managed as a self-contained unit, maximizing the value of their own shares for their shareholders? Or should they be managed as part of a marketplace influenced by modern portfolio theory, maximizing the value of their -- mostly diversified -- shareholders' overall investments? 10
So take stock buybacks, a pet peeve of many people, including Elhauge. 11 My view of stock buybacks is that they're about who gets to allocate capital to projects: Those who dislike buybacks (implicitly) think that corporate managers should be making decisions about what projects to pursue, while those who advocate buybacks think that investment managers 12 should be making those decisions. In a modern-portfolio-theory world where investors can costlessly invest in whatever companies they want, there's a pretty high bar for corporate managers making new investment decisions: Why is this project better than anything else my shareholders could do with their money? But in a world where each company acts on behalf of undiversified shareholders, of course managers should be investing aggressively: They are the whole world (of investment opportunity) to their shareholders, and if they don't take risks on behalf of those shareholders then no one will. 13
More abstractly, this is a fight over how to conceive of corporate capitalism. The old-fashioned way of thinking is organized around distinct companies. Company X is its own thing; its managers should dislike the managers of Company Y, its workers should dislike the workers of Company Y, its consumers should dislike the products of Company Y and its shareholders should dislike the shareholders of Company Y. And all of them should like each other: They're all in it together, down at Company X, against the world.
The modern way of thinking abstracts shareholders away from their companies 14 : Company X isn't Company X, it's just a beta, a collection of risk factors that deserve a certain weight in your portfolio. Shareholders have no emotional connection to any particular company. They follow investing best practices, seeking diversification and shareholder-friendly governance and efficient capital allocation and maximum risk-adjusted return. And by abandoning individual companies, shareholders attain a certain class consciousness, pushing all companies to do what is right for the shareholder class, rather than pushing each company to do what is right for itself. This is the dominant line of thinking in modern finance. You can see why some people find it scary.
Now, for myself, I wouldn't ban index funds. Most of my money is in index funds. I am willing to believe that sometimes managers act anticompetitively because they think it's in shareholders' best interests, but the evidence of the magnitude of the problem seems a bit thin, and I think that the well-established benefits of diversification outweigh the still uncertain costs.
But I like the index-fund conspiracy theorists because their claims are so bold. They claim -- outrageously (for law and business school professors!) -- that modern corporate capitalism is bad for the economy, but not for any sort of agency cost reasons. Rather, it's bad in its best form. Managers aren't acting against shareholders' interests, and shareholders aren't excessively focused on the short term. Managers are loyally and correctly maximizing the value of their shareholders' portfolios. And those shareholders are investing rationally and correctly in diversified portfolios that maximize risk-adjusted return. Everything about the system is working perfectly. And it's still bad.
See footnote 141 (to the first sentence of the passage quoted):
See Matt Levine, Capital Charges and Illicit Indexing (July 21, 2015), available at http://www.bloombergview.com/articles/2015-07-21/capital-charges-and-illicit-indexing (incorrectly asserting that this was my claim in a prior draft of this article).
But that's wrong: I never said that Elhauge said that index funds are "inherently illegal." I said that he said that they're "already illegal." I continue to think that that is the correct reading of his argument.
To be fair, I also interpreted him to mean "that we would have somehow made it a felony to own an index fund without anyone noticing," which I confessed was an exaggeration. As he points out, criminal antitrust charges for diversified investing seem far-fetched; his focus is on civil actions.
On the first point: Market definition is a subjective matter, and it's hard for an indexer to know in advance if, for instance, dollar stores compete only with other dollar stores (concentrated) or with Wal-Mart et al. (less concentrated, or at least, less market share for the dollar stores). On the second: Airlines are Elhauge's paradigm case, and three of them are in the S&P 500, along with other companies (Google, Microsoft) that have had antitrust troubles.
Also it raises the same market-definition problems as the first response: Can you invest in both Facebook and Google, or are they in the same industry?
E.g. (page 14):
Ordinarily, high profits induce corporations to invest in expansion to try to get a greater share of those high profits, and that expansion in turns leads to high levels of economic growth and employment. Recently corporate profits have risen to record levels, nearly $2 trillion dollars per year, four times the corporate profits in the late 1990s and higher as a percentage of GDP than any time in the last sixty years. But despite that spending, U.S. corporate investments in expansion and capital projects have fallen; indeed, corporate investments were nearly 50% higher as a percentage of GDP in the late 1990s as now.
And (page 15):
As Paul Krugman has observed, “this kind of divergence — in which high profits don’t signal high returns to investment — is what you’d expect if a lot of those profits reflect monopoly power rather than returns on capital.” But what would that unexpected exercise of monopoly power be? After, all we have antitrust laws that are actively enforced by government agencies and private actors to curb anticompetitive creations of market power.
Perhaps the explanation is that we now have pervasive horizontal shareholdings because more and more stock is in the hands of institutional investors but we have not, so far, had any antitrust enforcement against it because the anticompetitive problem was until recently unappreciated.
Nor do I think that, like, Vanguard calls up airline executives to discuss route planning. When big diversified shareholders talk to managers it's probably more about corporate decisions -- capital return, mergers, etc. -- than competitive ones. On the other hand, here are Azar et al.:
The former legal counsel of a very large asset management firm tells us in personal communication that “high on the list of topics” discussed in engagement meetings is how portfolio firms can “throw the switch from developing market share to instead exercise market power to get margins up” in particular markets. “Antitrust considerations are generally not on the radar” during such conversations.
One small exception to this is that shareholders now have a vote on executive pay, and Elhauge argues that pay packages give executives incentives not to compete by paying them mostly for industry performance, not their own firms' outperformance. But the shareholder vote doesn't really cause that pay structure: The shareholder vote is non-binding, and anyway similar pay structures existed before the Dodd-Frank "say on pay" rules. In fact Elhauge's evidence for the existence of non-competitive pay is cited to the 2006 edition of a book by Lucian Bebchuk and Jesse Fried. Dodd-Frank was passed in 2010. It's not like shareholders design compensation packages; they just approve them.
Elhauge himself makes that point: "For that matter, it suffices that institutional investors have incentives to fail to exercise their corporate governance rights in a way that demands maximizing individual corporate performance over industry performance." He cites the example of DuPont, whose diversified shareholders rejected an activist effort to (arguably) compete harder against Monsanto. Schmalz has made that argument at length here, and I discussed it here.
I mean, on one popular (but disputed) theory.
Again I am not an antitrust lawyer, but I am not convinced:
The so-called passive investor exception is not to the contrary. What the relevant provision provides is that Clayton Act §7’s condemnation does “not apply to persons purchasing such stock solely for investment and not using the same by voting or otherwise to bring about, or in attempting to bring about, the substantial lessening of competition.” Getting the benefit of this exception thus requires proving both of the following elements: (1) the stock acquisition must be solely for investment; and (2) the acquired stock must not actually be used to lessen competition substantially or to attempt to do so.
The first element requires proof that the investment is purely passive, which excludes not only investments that give working control, but also investments that give the stock acquirer any influence over the corporation's business decisions or access to the corporation's sensitive business information.
In the corporate and securities law contexts with which I am familiar, it's pretty clear that Vanguard et al. are in the "solely for investment" camp, even if they do vote and talk to management sometimes. Active investors are the sorts who make big high-stakes public demands for mergers, divestitures and radical changes, not those who have quiet non-confrontational chats with management.
The second element means that even when an investor can show it is purely passive in the antitrust sense, the passive investor exception does not apply if the acquired stock is actually used, by voting or otherwise, to lessen competition substantially or to attempt to do so. The effect, as courts have noted, is that the passive investor exception is not really an exception at all, but rather means that a different burden of proof applies to purely passive investments.
I guess? I just don't think that econometric evidence of higher ticket prices is enough to prove that Vanguard is guilty of an antitrust conspiracy. "X lessens Y" is a different statement from "X is used to lessen Y"; the latter seems to me to require some evidence of active intent. Sure if investors were calling up managers and saying, "Don't cut your prices, I'll convince your competitors not to cut theirs either," that would be illegal, but you knew that already. Just the fact of buying passive stakes in a bunch of firms -- I mean, maybe a court would find that illegal, but it seems weird to me. I realize that's not a particularly rigorous legal argument, but you've probably stopped reading this footnote by now anyway.
As I've mentioned before, mergers are an obvious context. Value-destroying overpriced empire-building mergers are great for concentrated shareholders of the target; they are bad for diversified shareholders who own the market and don't want to see market value destroyed.
"Instead of spending to expand output, corporations have retained between $3.5 trillion and $5 trillion dollars in cash and spent other profits on stock buybacks, dividend payments, and high executive compensation."
Or "investors," but realistically we are talking about a dispute between professional managers of companies and professional managers of investment funds. Agency costs everywhere.
Of course index funds -- as opposed to generic modern-portfolio-theory investors -- aren't really actively allocating capital. They are free-riding on the allocation decisions of others. Which actually seems sort of analogous to the Elhauge/Posner/Weyl/Azar/et al. argument: By de-emphasizing capital allocation decisions, indexers make those decisions lower-stakes ("Everyone gets money!"), which makes for less efficient capital allocation and less competitiveness. (I don't find this mechanism wholly convincing either: Index funds free-ride on the capital allocation decisions of others, but others are still making those decisions, and indexers just have the effect of magnifying and leveraging the decisions of others.)
Loosely and tentatively speaking, it abstracts managers away along with them: The managers went to business school, studied modern portfolio theory and identify with the shareholder class. Workers and consumers did not necessarily go to business school, so they are to some extent left behind, though of course their bonds with companies are fraying too.
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