Values Added

The Atlantic is asking “Are Index Funds Evil?”

The Atlantic recently published a piece asking a very interesting question: do index funds have the (accidental) impact of limiting competition and driving up prices? Really smart people are taking both sides of the debate. That’s a good sign that it’s worth thinking about.

In April 2014, Azar, Schmalz, and Tecu posted an early draft of a paper titled “Anti-competitive Effects of Common Ownership.” The paper made several astonishing claims. Overall, it said, the high concentration of share ownership had caused serious harm to consumers in the airline industry: Ticket prices were as much as 12 percent higher than they otherwise would have been, because of common ownership of shares. The authors measured how competitive individual routes were, based not only on how often each airline flew a given route—which regulators already examine—but also on the degree to which each airline’s shares were held by common investors. They found that adding common ownership increased the level of concentration on the average route to more than 10 times higher than the levels that regulators presume to be a problem. The paper noted that three mutual-fund families—BlackRock, State Street, and Vanguard—collectively control about 15 percent of the shares of major U.S. airlines, although these funds are by no means the only common owners. At the end of 2016, for instance, Berkshire Hathaway, Warren Buffett’s company, owned 7.8 percent of American Airlines, 8.3 percent of Delta, 7 percent of Southwest, and 9.2 percent of United Continental.

A few initial thoughts with the caveat that I haven’t read the underlying papers yet:

1) The idea that firms will become non-competitive based on investor pressure is plausible but that pressure would push against the intensity and culture of most firms and industries. Further, financial incentives are only one area of influence on firm leaders (who are often competitive alpha types).
2) The air travel industry is sufficiently atypical that in almost all cases one shouldn’t extrapolate findings in that industry to the market as a whole.
3) There is still a lot of non-index money invested (most of the money!) and there are still activist investors so even if this was a potential problem, presumably it is muted in impact some by all the other investors.
4) The government ought to insure competition and it should examine this issue and consider whether it might be able to engage in a way that helped.
5) The rise of Vanguard and other indexers and their substantial and growing market power means they need to be much more careful about corporate governance and shareholder proxy issues.
6) Low-fee index funds have created a huge amount of value for middle-class investors (as well as wealthy investors).
7) If the problem hurts all consumers but benefits some investors, that would create additional inequality and would be very concerning. The bigger the impact, the more it should concern us.
8) Bonus thought on index funds: they tend to increase tax efficiency of investing which also contributes to income inequality.