Passive Investing Might Not Be Great for Growth
When United Airlines called security to drag passenger David Dao off of his flight back in April, some observers cheered the airline’s falling stock price, expressing the hope that this would punish the company’s executives and owners and spur them to implement a more passenger-friendly attitude. United’s stock quickly recovered. But even had it fallen a lot and not bounced back, there’s no guarantee it would have been a big deal for the company’s largest shareholders.
The reason? Those big shareholders are also likely to own pieces of United’s competitors. For example, Berkshire Hathaway Inc. -- Warren Buffett’s firm -- is the largest shareholder in United Continental Holdings. But Buffett has also taken large stakes in three of United’s major U.S. competitors -- Southwest Air Co., American Airlines Group Inc., and Delta Air Lines Inc. So if people had abandoned United in disgust and fled to one or more of those rival airlines, their profits would have gone up as United's went down -- and Berkshire’s bottom line would have felt little or no pain at all. United’s other biggest shareholders -- institutions such as Vanguard Group -- are probably also highly diversified. So very few of United’s owners are likely to care when the airline makes a big mistake and sends business to its competitors. And it’s not just airlines -- look at the main shareholders of Bank of America Corp. and JPMorgan Chase & Co., for example, and you’ll see many of the same names as the biggest shareholders.
This was pointed out to me on Twitter by University of Navarra IESE Business School economist Jose Azar. Along with his colleague Martin Schmalz of the University of Michigan’s Ross Business School, Azar has been pursuing a fascinating, novel and disturbing hypothesis -- the idea that common ownership is making companies and the economy less competitive. In 2017, Azar and Schmalz found evidence that when airlines started to be owned by the same investors, ticket prices on routes where those airlines competed went up. The implication is that the new owners put less pressure on the airlines to compete, allowing them to jack up prices along their shared routes. My Bloomberg View colleague Matt Levine flagged this research back in 2015, but the policy world has been slow to take it seriously.
If this really is happening, it’s very worrying for the U.S. economy -- and for all economies with well-developed financial markets. In recent decades, U.S. industries have been getting more concentrated. That’s bad. Monopoly power tends to lead to higher prices and lower productivity, and it also probably contributes to income inequality. But if Azar and Schmalz are right that common ownership is reducing competition, that adds a second powerful force making the economy less productive, less consumer-friendly, and more tilted toward investors rather than workers. As Levine points out, common ownership is rarely if ever taken into account in antitrust cases.
Why would common ownership be increasing in the U.S. and other rich economies? Perhaps because common ownership is mostly a function of diversification. As investors become more diversified, they tend to own shares in most of the major companies in an industry. And when everyone owns a little piece of every company, then every company has the same set of owners.
In the U.S., passive investing -- buying exchange-traded funds and index funds that include many or all of the stocks in an index -- is rapidly becoming more common:
But passive investing is only one way to diversify. Actively managed mutual funds and large institutional investors may not track the index, but most of them are very diversified anyway. Retail investing -- individual investors buying their own stocks -- has largely given way to institutional money management in recent decades. Thus, banning index funds, as a few writers have proposed, would do little or nothing to reduce common ownership. Even individual retail investors have been hearing the gospel of diversification for decades now -- hold more than 30 stocks, and your idiosyncratic risk goes way down with no reduction in your expected return. Diversification is taught in every introductory investment class as a magic tool for eliminating unnecessary risk. I taught it myself for years without ever thinking about potentially negative economic consequences.
Now, the case that common ownership stifles competition is far from settled science. Antoinette Schoar, a finance professor at the Massachusetts Institute of Technology’s Sloan School of Management, expressed skepticism about Azar and Schmalz’s idea when we spoke at the American Economic Association’s annual meeting in Chicago this January. Schoar speculated that even if most of a company’s investors are big, well-diversified institutions and funds, it will always be a few highly motivated activist investors who drive corporate policy. Large diversified investors, she says, will simply get out of the way and let the activists, who care about the stock’s value, push managers to compete.
Schoar is definitely right about one thing -- in order to establish a firm link between diversification and lack of competition, researchers must think carefully about the process by which investors actually pressure companies to compete with each other. One potential reason to be skeptical of Azar and Schmalz’s result is that it seems implausible that even the most concentrated investors would evaluate an airline’s routes one by one and pressure the board of directors to cut or raise prices on certain routes. Investors tend to exercise control over companies in much more long-term, indirect ways, like electing directors.
Nevertheless, Azar and Schmalz’s idea deserves a lot of attention and follow-up. Fortunately, policy makers are already starting to pay attention. For example, economist Jason Furman, an important policy adviser to Democratic politicians, has reportedly managed to convince Massachusetts Senator Elizabeth Warren that common ownership represents a threat to the workers of America.
That’s good news. Instead of simply resolving to tax the rich more, politicians should think about how the structure of the economy can be reformed to reduce inequality while also boosting productivity. Increasing competition would be good for workers, but it would also be good for the economy.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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James Greiff at firstname.lastname@example.org