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Much ado about nothing: The impact of diversified funds on competition

A new line of research suggests that diversification across stocks in an industry can reduce competition, but that argument is weak.

Alex Bryan 23 January, 2018 | 6:00PM
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Does common ownership of stocks in the same industry reduce competition? That is the central question that an emerging body of academic research is seeking to address. While this research is still in its early stages and the evidence is inconclusive, the policy reactions it might elicit could be significant for investors.

Some proposals have suggested limiting an asset manager's holdings to one stock in each industry where its ownership stake in a firm exceeds 1%, which would effectively ban large index funds, and preventing asset managers that own two or more competitors from exercising their voting rights. But the underlying argument that common ownership leads to less competition relies on some misguided assumptions.

At the heart of this argument is the idea that shareholders who own multiple firms in the same industry (common owners) have an incentive to maximize industry profits, rather than individual firm profits. So, they behave in ways that concentrated investors wouldn't, by not pressuring managers to compete aggressively, or otherwise using their influence to discourage competition and boost industry profits. Jose Azar (an economist at IESE Business School) and his colleagues developed this argument in two studies (found here and here) that found that an increase in common ownership in the airline and banking industries was associated with higher prices for the services those firms offered.

Consider the U.S. airline industry, which is dominated by  Southwest (LUV),  Delta (DAL),  American (AAL) and  United (UAL). Imagine one investor buys up all four companies, which is effectively a merger. Clearly, that owner could exercise operational control over the combined entity and would raise prices on the routes where the independent firms previously competed. The common ownership argument predicts that there would be a similar anticompetitive effect when investors hold minority stakes in competing companies.

While this argument can be used against any large investor who owns more than one stock in the same industry, it is particularly problematic for index managers, since they mechanically own all the stocks in an index and are often among the largest owners of these stocks. Their influence will keep growing as assets continue to shift from actively managed to index funds.

Flawed assumptions

For the common ownership argument to work, four things must be true:

  1. Firms with common owners would be more profitable individually if they competed more aggressively than they are currently.
  2. Corporate managers don't have proper incentive to act in their own firm's best interest.
  3. Managers prioritize common owners' interests over other shareholders.
  4. Common owners apply less pressure on managers to deliver strong performance than investors who only own one stock in an industry (concentrated investors).

Only the last assumption is credible -- at least for institutional investors. Because the other three are not, common ownership should have no bearing on competitive behaviour or consumer prices.

It is not always in a firm's individual interest to compete more aggressively because actions designed to take market share away from competitors, like price cuts and cutting-edge innovation, often elicit a competitive response that could hurt profits. For example, if American Airlines cuts fares on a route, its competitors will likely follow suit, leaving American (and its competitors) in a less profitable position. When it is not in a firm's individual interest to compete more aggressively, the mix of common and concentrated investors should have no effect on firm behaviour because these investors' interests would be aligned--both groups would prefer less competition. That doesn't mean that firms behave the same as they would if they were part of a cartel, just that they wouldn't necessarily compete more aggressively if common owners were out of the picture.

As long as managers have incentive to maximize their own firm's value -- as most do -- an increase in common ownership shouldn't lead to less competitive behaviour. It is a stretch to presume that a firm would compete less aggressively to help its competitors, if doing so meant sacrificing its own profitability. Corporate managers are going to do whatever they think will maximize their own wealth, even if common owners aren't applying as much pressure for them to do that as concentrated investors.

Corporate managers' fiduciary obligation extends to all their shareholders. So, even if common owners have a vested interest in reducing competition in a manner that is inconsistent with maximizing the value of the firm, it isn't clear that managers would favour their interests over shareholders who don't own any of the firm's competitors. Doing so would violate the firm's fiduciary obligations.

A more holistic view

Suppose that the common ownership argument is accurate: That index (and other diversified asset) managers look the other way while firms adopt less competitive behaviour to increase industry profits. It isn't necessarily in asset managers' interest to do that. Rather, if they were able to affect how companies competed with one another, it would be in their interest to use that influence to maximize the value of their entire portfolios. That means they would favour their larger holdings over their smaller holdings, and might even benefit from greater competition (and lower prices) in some industries whose goods and services are expenses for their holdings in other industries. Take the energy industry, for example. Energy stocks represent less than 6% of  Vanguard U.S. Total Market ETF (VUN), but energy prices affect most companies' expenses. Greater competition in this sector might be better for index investors than less. The banking and airline papers ignore these cross-industry effects.

With this in mind, it isn't obvious that index managers would benefit much at all from oligopolistic behaviour in the airline industry. Airline stocks represent a small fraction of most index funds (less than 0.5% of VUN), and yet travel expenses impact most publicly traded companies. Higher ticket prices especially hurt the hotel, restaurant and leisure industry, which represents a larger portion of most indexes than the airline industry. This demonstrates that the net effects of less competition and higher prices in one industry aren't necessarily beneficial for diversified asset managers.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.

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