Mutual funds with assets that mirror the composition of large market indices or industries, known as index funds, are widely hailed as a positive financial development. They offer a single financial asset that allows common investors to buy into markets without worrying about diversification since the fund is already diversified. Yet that diversification might have a downside, according to some new research, because the web of common ownership might be undermining competition.
In a column for Slate, University of Chicago Law School professor Eric Posner and E. Glen Weyl, a senior researcher in economics at Microsoft Research New England, point to evidence that cross-ownership of firms results in rising prices for the products and services provided by those firms, which directly harms consumers. Why would this happen? Imagine an index fund with shares in two companies that are in direct competition. Let’s say the companies are Delta Air Lines, Inc. and United Continental Holdings, Inc., the owner of United Airlines. For an index fund, it is actually in its best interest for the two companies not to compete because that might reduce the share prices of both firms.
Posner and Weyl cite a paper by José Azar and Isabel Tecu of Charles Rivers Associates, and Matin C. Schmalz, an economist at the University of Michigan, that looks specifically at the airline industry and cross ownership. They find that increased cross ownership actually results in an increase in airline ticket prices of between 3 to 11 percent. As Posner and Weyl point out, it’s as if index funds have replicated the old trusts that used to dominate the U.S. economy in the 19th century.
Their solution: Congress should outlaw index funds.
Unsurprisingly, that argument has not been received well in some corners. The headline of Matthew Klein’s article at FT Alphaville says it quite bluntly: “Law professors come up with zany plan to ruin your retirement.” Klein is skeptical of the research given the example of the airline industry, which has had trouble making profits and boasts a long history of bankruptcy since its deregulation in 1973. He also points out that it’s not clear whether more activist investors who target ownership in just one of the airlines would necessarily drive the prices for airline tickets down rather than just get the company to pay out more money to shareholders.
This gets at a broader point that Matt Levine at Bloomberg View points out. Posner and Weyl assume that increased competition at the expense of returns is more progressive as the average shareholder is richer than the average consumer. But remember Klein’s point about payouts to shareholders. Levine adds that consumers are also workers. Increased competition and pressure from investors might drive down wages in addition to prices. So the progressivity of the trade-off between index funds and lower consumer prices isn’t as evident as Posner and Weyl would have us believe.
The unconvincing nature of Posner and Weyl’s specific proposal, however, isn’t enough to push aside the underlying issue. Joshua Gans, a professor at the University of Toronto, argues that the role of ownership of firms and its effect on competition cannot be ignored. Indeed, the topic has long been studied in economics. Gans highlights one aspect of this field of research—the role of wealth inequality and firm ownership. He notes that high levels of wealth inequality can interact with firm ownership to seize market power and “rents” (economics speak for monopoly-like profits) in an economy. In fact, wealth inequality is highlighted as an important factor in José Azar’s dissertation, which served as the foundation for the paper highlighted by Posner and Weyl.
So the increased cross-ownership of firms appears to have an effect on competition and the distribution of resources. But the idea that outlawing index funds—a potentially important source of low-cost retirement savings for a broad swath of workers—seems to be unwarranted. Perhaps we should be more concerned about the distribution of ownership by wealth level.
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First, as Weyl notes, increased competition in a market where firms have a lot of market power may actually increase wages. Market power decreases labor demand and that pushes wages down. Increased competition could reduce market power, increase labor demand, and boost wages. This would actually increase the progressive effect of their proposal as lower consumer prices and higher wages would mostly help households at the bottom and middle of the income distribution.
Secondly, Posner argues their proposed reform of mutual funds wouldn’t significantly harm the returns of middle-class investors. He states that “the gains from further diversification within industries after the benefits from diversification across industries are obtained, are tiny.” In other words, mutual funds that can only diversify across industries and not within wouldn’t be much worse off than index funds. Weyl says the two are working on quantifying this.
Finally, Posner says that the mutual fund change is not “an exclusive remedy.” The core problem is cartelization and market power, so increased enforcement of antitrust law would be a straight forward response. Given the evidence of market power and monopoly rents elsewhere in the economy, this proposal is quite reasonable.