This is Part I in a two-part series in which I address the argument that: 1) index funds are seizing an outsized influence over publicly traded corporations, and 2) that they are wielding this influence so as to reduce intra-industry competition between firms in their portfolio. In this post, I summarize the argument and offer some criticisms as to why this influence may not be as significant as it appears. In Part II, I will proceed to argue that, to the extent that index funds have indeed acquired some influence over the firms in their portfolio, this may in fact be a salutary development.
I. “Common Ownership” and Anti-Competitiveness
Over the past two decades, “passive” funds which maximally diversify their portfolios by investing in an entire market index (e.g. the S&P 500) have acquired an increasing percentage of the total shares traded on these indexes. Such funds are passive insofar as they merely track the market as a whole, vs. actively managed funds which conduct market research so as to invest in undervalued firms and to short overvalued ones, thereby earning “alpha” (above-market returns). Yet the fact that just three index funds: Vanguard, BlackRock and State Street (the “Big Three”) represent a dominant share of the index fund industry, which is itself a rapidly growing portion of the overall stock market, has raised concerns over the influence which this concentration confers to these funds’ managers.
Three recent academic articles in the law and economics discipline outline the dangers posed by this emerging paradigm. John C. Coates and Einer Elhauge of Harvard University Law School have published, respectively, The Future of Corporate Governance Part I: the Problem of Twelve (2017) and Horizontal Shareholding (2016). These pieces are joined by Eric Posner, Fiona Scott Morton, and Glen Weyl’s A Proposal to Limit the Anti-Competitive Power of Institutional Investors (2017).
This hand-wringing has leaked out of the ivory tower. These analyses have formed the basis of popular news coverage, “The Dark Side of Mutual Funds” - Slate, 2015; “Rise of Institutional Investors Raises Questions of Collusion”- New York Times, 2016; “Are Index Funds Evil?” - The Atlantic, 2017. In 2016, the antitrust division within the Department of Justice cited this research in expressing its interest to seriously investigate the issue.
The tone of this coverage is redolent of Progressive Era descriptions of an economy dominated by trusts and oligopolies, wherein a small coterie of businessmen exerted a malign, sub rosa influence on the wider economy at the expense of the rest of us. And just as that narrative generated enthusiasm for political remedies including the Sherman Antitrust Act, the Clayton Act, and a Federal Trade Commission, so all three of these academic pieces - and their amplificatory media appearances - explicitly argue for either new legislation or the novel application of extant legal mechanisms (e.g. Section 7 of the Clayton Act) to address this growing threat.
Their argument proceeds as follows: first, we observe the straightforward fact that an index fund is often the plurality shareholder (over two-thirds of all >5% equity stakes are held by one of the Big Three) in one of its portfolio firm’s stock, and together index funds frequently constitute a 15-20% stake in a given firm. This institutional position confers influence over a firm’s important strategic decisions, either via formal governance mechanisms such as shareholder votes on resolutions, managerial pay and board composition, or via informal consultation with management.
For Coates, this amount of influence wielded by so few hands (the eponymous Twelve) is concerning in and of itself. For Elhauge as well as Posner, Morton and Weyl, this influence is not malignant per se, but becomes so when coupled with the fact that these index fund managers have incentives which are at odds with not only the other shareholders of any given firm in their portfolio, but with the broader economy. Because an index fund is simultaneously invested in all of the major, publicly traded firms in a given industry, its incentive is not to maximize the share value of any given firm in that industry, but to maximize the aggregate share value of the entire industry. In a refashioning of the cross-shareholder models best explicated by anti-trust scholars Salop and O’Brien (2000), itself predicated on the intuitions of Cournot oligopolistic competition, these papers argue that index funds will pursue the tried-and-true profit-maximizing strategy of suppressing intra-industry competition, and will leverage their institutional influence as dominant shareholders to select for compliant, unaggressive management for this purpose.
An article in the Fall 2018 issue of Regulation does an excellent job of criticizing the methodology and mechanisms undergirding the empirical evidence for the anti-competitive effects of “common ownership”. In this post, I aim to complement Lambert and Sykuta’s economic analysis by highlighting the ways in which the “common ownership” paradigm makes key mistakes in its assumptions about the nexus of corporate governance relationships which exists between index fund managers, portfolio firm managers, and minority shareholders. I will dispute both component claims: 1) that index fund managers wield an outsized influence over the firms in their portfolio, and 2) to the extent that they do wield influence, its net effect on the economy is negative.
II. Index Fund Managers- Influence or Impotence?
All three articles argue that index fund managers will exercise their formal control rights qua shareholders to great effect. Shareholder resolutions, managerial compensation, and other significant governance questions are frequently decided by shareholder vote, and in this capacity index fund managers often do have a numerical advantage vis-a-vis any other single shareholder. Coates notes that even when they fall far short of a controlling bloc, index funds, either individually or as a group, often constitute the median voter, whose support is definitionally required for a resolution to succeed. This swing-vote role becomes particularly important when a contest for corporate control itself is at stake: when the composition of the board or the management is disputed, or when a merger is pending approval. In their capacity as the pivotal voter, index funds can select managers and board members who are willing to abide the suboptimal firm values resulting from the “soft” competition practiced in pursuit of intra-industry collusion.
Beyond the formal control mechanisms exercised qua shareholders, index fund managers are also capable of exerting informal pressure on the firms in their portfolio via “engagement”. Coates is worth quoting at length:
A second channel of influence is through what institutional shareholders call “engagements.” Their staffs “meet” – sometimes in person, more often by phone, sometimes just by email – with representatives of their portfolio companies. Through these meetings, they try to influence management, by informing them of their policies, their approach to new issues, and their perceptions of management and how it is responding to corporate challenges. These engagements can last a few minutes, or a few hours. Even if the out-of-pocket cost of an engagement is quite low, the impact of the information provided during the engagement have important effects on portfolio companies, as amplified through the managers of that company. That is because the engagements provide important signals to managers as to how the investors will behave should votes come up, on issues, or on other matters, including control contests, activist campaigns, or mergers. The prospect of such events – and the power of index providers in those events…provides a powerful incentive to portfolio company managers to respond to the desires, however economically expressed, of the index provider agents.
We can draw on a basic tenet of organization theory: the choice of exit vs. voice (Hirschman 1970), to demonstrate how proponents of the “common ownership” paradigm have overstated their case for index fund influence. Members of an organization may affect said organization’s decisions via formal voting mechanisms, informal pressure and persuasion (voice) or they may leave (exit). Exit not only has compositional effects by shifting the median voter of the remaining members, but may be exercised as a threat to induce cooperation. While the authors here outline two plausible mechanisms whereby index fund managers may possess a loud voice over a firm’s corporate governance decisions, they omit in their analysis the index funds’ unique weakness as investors: they cannot choose to exit (that is, sell) a firm’s stock if they disagree with its management. Because the voice and exit strategies are complementary, index funds’ lack of a credible exit threat makes their voice less stentorian than it at first appears.
A profit-seeking management team must appeal to the marginal, exit-capable shareholder in order to maximize share price. For the same reason that Apple doesn’t optimize its next iPhone to satisfy Apple die-hards, and Democratic presidential candidates don’t campaign on the coasts, management teams won’t be overly worried about catering to their captive shareholders.
Let’s dwell on the Apple analogy for a moment. In designing the newest iPhone, Apple may be weighing the choice between designing a faster processor or a better camera. Apple enthusiasts would value a faster processor much more highly. But the casual consumer, interested in taking the most flattering Instagram selfies, will place more value on the better camera when comparing the iPhone with the latest Samsung. Apple’s incentive, then, is to appeal to this marginal consumer. The enthusiasts, who are already willing to pay more for the iPhone than its sticker price - faster processor or not - are the inframarginal consumers. A firm’s management, with much of its own compensation tied to the firm’s share price, will be incentivized to pursue those strategies which the marginal shareholder believes to be value-maximizing, as reflected in the movement of the share price.
Deprived of the exit option, and with a precarious persuasive perch, index funds must utilize the formal component of their voice - voting in shareholder resolutions and, more importantly, control fights - to militate against a management otherwise incentivized to maximize share price. Yet even a cohesive bloc of the Big Three index funds, amounting to a hypothetical 20% stake in a given firm, will only be the median voter within a certain subset of shareholder votes. They will only be able to carry a vote in which the remaining shareholders are split more narrowly than 62.5-37.5. Within this range of sufficiently controversial choices, index funds managers, assuming they will vote cohesively, can have their way. But the “common ownership” argument means that this swing-vote role will be deployed to defend a management team, a board of directors or a major strategic initiative which will not maximize firm value. This 20% bloc can be assumed to be the only voters who are not trying to maximize firm value. Index funds will not be able to install their preferred management/directors/initiative if at least 62.5% of the profit-maximizing shareholders detect that this is not the profit-maximizing move. Even in a rational expectations model in which agents can only predict the expected value of a decision within some probabilistic distribution, nakedly non-profit-maximizing proposals will not garner the requisite 37.5% support from profit-maximizing shareholders. In the final analysis, index funds’ voice over corporate governance decisions sounds less baritone and more falsetto.