Will Index Funds Kill Competitive Capitalism?

Below is a complimentary Demography Unplugged research note written by Hedgeye Demography analyst Neil Howe. Click here to learn more and subscribe.

NH: Everybody knows that passive institutional investors hold a large and growing share of U.S. equities.

As of 2020, according to the Boston Fed, passive funds accounted for 48% of all MF and ETF AUM, up from 14% in 2005. Over the last decade, according to other researchers, the holdings of the "Big Three" passive indexers (Blackrock, Vanguard, and State Street) have grown from 5.2% to 20.5% of the S&P500.

Collectively, they are the biggest single shareholder of practically every large publicly traded company. And in recent years they have often accounted for nearly 100% (and sometimes even more than 100%) of the net inflows into all investment funds.

The upside of passive investing is obvious, and it no doubt accounts for the robust growth of this asset class. It offers most retail equity investors--who do not trust their ability to pick better-than-market active managers--an effortless and nearly costless way to track the market with instant diversification of risk.

But what about the downside? One danger that worries traders and the Fed is the possibility that growing passive investment heightens the risk of "crowded" unidirectional trading.

If most investors are tracking the market, they may be counting on other (active) investors to be thinking about whether its direction makes sense. But those "other" investors may be losing either the resources or the desire to buck the market's direction.

The result could be wild bull markets followed by wild bear markets--a herd psychology, weaponized by programmatic algos, in which overcorrection serially follows overcorrection. Think of the "flash crashes" of 2010 or 2015. Or the "tech wreck" of 2017. Or the breathtaking 34% drop last March (the fastest 30-day decline of that magnitude in stock-market history).

Yet there is another, longer-term danger that has attracted growing attention from economists and policymakers of every political persuasion. Consider: If a growing share of all investors are passive market trackers, then--almost by definition--a growing share of all beneficial owners of a large firm are also owners (on a pro-rata market-value basis) of all of that firm's large competitors.

And what do we call it when the same people own a large share of every firm in an industry. That's right: we call it "common ownership," a.k.a. monopoly. In such cases, at the very least, we look into the possibility of "monopolistic" firm practices--such as higher prices, fatter margins, lower output, less cost-control, and fewer innovations.

I've been following the growing volume of research into this topic for several years. See "Shhh! The Markets Are Concentrating," "Investors Pass on Active Management," and "Declining Business Dynamism Weighs Heavily on the Fed."

Worries about the rising pricing power of America's largest firms--along with their growth as a share of the S&P500--were further heightened during the pandemic. (See "The Inexorable Triumph of Bigness.")

The challenge of rising market concentration and less intra-industry competition, with special emphasis on the growing role of "common ownership" by investment funds, was first brought to the policy world's attention in 2016 by the White House CEA.

The next year, an NBER article ("Declining Competition and Investment in the U.S") focused specifically on how common ownership substantially raises the standard Herfindahl–Hirschman Index (HHI) measure of market concentration and steepens its rising trend over time.

This chart (which I use in my presentation "Declining Business Dynamism: A Visual Guide") compares two HHIs for the U.S. economy over time. The green line is the standard HHI for all firms in all product markets.

The red line "modifies" the HHI to include the effect of rising common ownership by institutional investors.

Meanwhile, a series of papers by Jose Azar at U Michigan and others woke up many economists by showing how common investor ownership in the airline industry was statistically correlated with a 3% to 10% price rise in air routes in which all the bidders were commonly owned.

Similar anti-competitive dynamics are now suspected in other industries, including banking, software, and pharmacies. A new generation of economists at U of Chicago's Booth School of Business--a sign of changing times, indeed--is aggressively building the case against common ownership and suggesting various antitrust remedies.

The former head of the Justice Department's antitrust division acknowledged that his agency now takes institutional shareholders into account when assessing market concentration. The European Commission and the OECD have also confirmed that common ownership now plays a role in antitrust monitoring.

Needless to say, all of the Big Three indexers deny there is any problem to worry about. If anything, they say, we are improving the management oversight of large firms. In 2017, then-Vanguard CEO Bill McNabb said "we care deeply about governance" and "Vanguard's vote and our voice on governance are the most important levers we have to protect our clients’ investments.” (Vanguard founder John Bogle conceded that passive growth could be a problem, but not until it reached about 75% of all ownership.)

Blackrock CEO Larry Fink similarly stated that, with the growth in indexing, “our responsibility to engage and vote is more important than ever.” Ditto for the State Street Global Advisors CIO, who announced that “SSGA’s asset stewardship program continues to be foundational to our mission.”

A recent award-winning study throws doubt on these claims. Lucian Bebchuk and Scott Hirst, two Harvard law and economic scholars, show in an NBER paper later published in the Columbia Law Review that passive investors dedicate few resources to governance. (Indeed, since any benefits to firms they hold would be shared by all other index funds, they have little incentive to pursue better governance.)

Relying heavily on proxy advisory services like ISS and Glass Lewis, they mostly engage in "check box" supervision and adhere only to overall "principles of governance." They rarely meet with firm managers and rarely vote against management.

Managers might take the "governance" of passive investors more seriously if they felt that it might affect company control. But that possibility is ruled out by SEC Rule 13(d) which requires expensive and lengthy disclosure by any investor acquiring more the 5% of a firm's shares "with the purpose of influencing the company's control." Such a purpose would make no sense for an index fund in any case.

So at every turn, the governance behavior of a passive investor appears to be literally "passive" with respect to management. There is little evidence of the sort of desire to maximize the future earnings of any one firm that we would expect of an active investor.

The effect of this passivity is strengthened by the fact that these large funds do vote at almost every opportunity, unlike many small retail active investors who often don't bother.

One big puzzle remains for those who argue that passive investing encourages monopolistic practices. It may be true that common owners in theory have a big incentive to collude. It may also be true that passive investors don't engage in serious governance. But all this still doesn't explain the actual mechanics of collusion. How can the interests of scattered and anonymous beneficial owners of index funds possibly affect the behavior of managers who probably have no idea who these owners are or what they want?

This puzzle makes policy makers cautious. FTC Commission Noah Phillips remarked that "areas of research that I, as an antitrust enforcer, would like to see developed before shifting policy on common ownership [are] whether a clear mechanism of harm can be identified.”

Former SEC Commissioner Robert J. Jackson has likewise said it was “far from clear how—even if top managers receive an anti-competitive signal from their pay packages—those incentives affect those making pricing decisions throughout the organization." Without knowing how monopolistic practices are encouraged, he would find it hard to change the rules.

Answering that question is the focus of the most recent research. Many economists now suggest that the sheer disinterest by passive fund managers in any real supervision is itself a signal to firm managers to engage in various types of monopoly-like behavior.

One multinational research team shows, in a paper released in April, that firms with greater passive investor ownership are more likely to adopt top management incentives that are less sensitive to performance. They also show that these incentives are likely to lead the entire firm to take fewer risks to cut costs, reduce prices, or expand market share.

The IMF working paper cited at the top of this note, released this month, bears the title: "Are Passive Institutional Investors Engaged Monitors or Risk-Averse Owners? Both!" The authors compare firms that (randomly) find themselves just inside the Russell 2000 threshold, and thus become part of the index, versus those that just miss.

They find, over time, that the indexed firms step up their performance in all the most easily monitored measures of activity, such as R&D spending and numbers of patents filed. But they also find a reduction in CEO power and incentives and clear evidence that these firms (now evaluated on near-term financial performance) choose less risky research strategies, shifting "more to exploitation than to exploration."

In effect, the new research is finding that the negative impact of common ownership doesn't have to work through outright collusion to raise prices and reduce output. It is enough that the investor is no longer as interested in whether the manager achieves a breakthrough at the expense of rivals--which, over time, is equivalent to raising prices and reducing output.

Few managers enjoy real risk, and most managers fear loss. As J.R. Hicks pointed out back in 1935 in his classic article on the theory of monopoly, "The best of all monopoly profits is a quiet life." 

But if it's the managers, not the investors, who are the ones enjoying the quiet life, we might correct Hicks by saying that this really isn't "monopoly" behavior per se. It's more akin to a breakdown in principal-agent coordination. In any case, it's clearly market failure.

The bottom line is that the spread of passive investing may be bad for the economy's long-term dynamism and growth. On the other hand, it should also provide even greater opportunities for the engaged active investor--to those who put their money on one horse and who really care about whether that horse wins.

There's a dynamic equilibrium here. At the extreme, even John Bogle admitted that "if everybody indexed, the only word you could use is chaos, catastrophe... The markets would fail.”

Yet long before that point is reached, the rewards of active management would become spectacular.

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ABOUT NEIL HOWE

Neil Howe is a renowned authority on generations and social change in America. An acclaimed bestselling author and speaker, he is the nation's leading thinker on today's generations—who they are, what motivates them, and how they will shape America's future.

A historian, economist, and demographer, Howe is also a recognized authority on global aging, long-term fiscal policy, and migration. He is a senior associate to the Center for Strategic and International Studies (CSIS) in Washington, D.C., where he helps direct the CSIS Global Aging Initiative.

Howe has written over a dozen books on generations, demographic change, and fiscal policy, many of them with William Strauss. Howe and Strauss' first book, Generations is a history of America told as a sequence of generational biographies. Vice President Al Gore called it "the most stimulating book on American history that I have ever read" and sent a copy to every member of Congress. Newt Gingrich called it "an intellectual tour de force." Of their book, The Fourth Turning, The Boston Globe wrote, "If Howe and Strauss are right, they will take their place among the great American prophets."

Howe and Strauss originally coined the term "Millennial Generation" in 1991, and wrote the pioneering book on this generation, Millennials Rising. His work has been featured frequently in the media, including USA Today, CNN, the New York Times, and CBS' 60 Minutes.

Previously, with Peter G. Peterson, Howe co-authored On Borrowed Time, a pioneering call for budgetary reform and The Graying of the Great Powers with Richard Jackson.

Howe received his B.A. at U.C. Berkeley and later earned graduate degrees in economics and history from Yale University.