THERE is a contradiction at the heart of financial capitalism. The creative destruction that drives long-run growth depends on the picking of winners by bold, risk-taking capitalists. Yet the impressive (if not perfect) efficiency of markets means that trying to out-bet other investors is almost inevitably a losing proposition. Algorithmic punters trade away the tiniest of arbitrage opportunities near-instantaneously. Active investment strategies therefore amount to little more than a guessing game: one in which, over time, the losses from bad guesses eventually top the gains from good ones. Betting with the market—through broad index funds, for instance—is therefore a good way to maximise returns. Yet where does that leave capitalism, red in tooth and claw, and its need for bloody-minded nonconformists?
“Passive” investment vehicles, like those low-fee index funds, now soak up enormous amounts of cash. In America, since 2008, about $600 billion in holdings of actively managed mutual funds (which pick investments strategically) have been sold off, while $1 trillion has flowed into passive funds. So the passive funds now hold gargantuan ownership stakes in large, public firms. That makes for some awkward economics. Research by Jan Fichtner, Eelke Heemskerk and Javier Garcia-Bernardo from the University of Amsterdam tracks the holdings of the “Big Three” asset managers: BlackRock, Vanguard and State Street. Treated as a single entity, they would now be the largest shareholder in just over 40% of listed American firms, which, adjusting for market capitalisation, account for nearly 80% of the market (see chart). The revolution is here, but it was not the workers who seized ownership of the means of production; it was the asset managers.
A growing number of critics reckon this cannot be good for capitalism. Some argue that because such funds take investors out of the role of allocating capital the outcome does indeed resemble Marxism (or worse, since communists at least dared to suggest that some activities were more deserving of capital than others). In August analysts at Sanford C. Bernstein, a research firm, thundered: “A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market-led capital management.” This is over the top. Passive investment pays because active investors rush to price in new information. If passive investors took over the market entirely, unexploited opportunities would abound, active strategies would thrive and the passive-fund march would stall.
Others worry that concentrated ownership will lead to managerial complacency. Actively traded mutual funds might sell a stake in a poorly managed firm; passive funds lack that option. Captive shareholders could allow management to run amok. Yet that worry, too, seems overstated. Passive asset managers can still be active shareholders. Most have signalled their intent to push executives for good performance. Rather, the big problem with concentrated ownership may be that firms are too mindful of the interests of their biggest shareholders. A fund with a stake in just one firm in an industry wants that firm to out-compete its rivals. Big asset managers, which take large stakes in nearly all of the dominant firms in an industry, have a somewhat different view. From their perspective, the best way to generate portfolio returns might be for rivals to treat each other with kid gloves.
In a series of recent papers, Martin Schmalz of the University of Michigan and a cast of co-authors work to detect the anti-competitive effects of concentrated ownership. Their results are striking. Institutional investors hold 77% of the shares of the companies providing services along the average airline route, for instance, and 44% of shares are controlled by just the top five investors. Adjusting measures of market concentration to take account of the control exercised by big asset managers suggests the industry is some ten times more concentrated than the level America’s Department of Justice considers indicative of market power. Fares are perhaps 3-5% higher than they would be if ownership of airlines were truly diffuse. In theory large asset-management firms might be quietly instructing the firms they own not to undercut rivals. But the writers suggest nothing so nefarious need occur to cause trouble. Fund-appointed board members could simply refrain from urging conservative CEOs to compete aggressively, or CEOs might anyway conclude that their big shareholders would prefer peace and profits.
Buy low, sell high
A similar analysis suggests bosses are rewarded handsomely for playing along. The authors note that large funds often approve generous pay packets for executives whether or not they are performing well. Indeed, in industries with highly concentrated ownership, bosses receive relatively less pay than peers when their firm does well, and relatively more when competing firms do well. The authors reason that a weaker link between executive pay and firm performance makes CEOs lose interest in aggressive competition, boosting profits across the portfolio as a whole.
Such findings should trigger alarm bells among regulators. There are no easy fixes, however. Limiting the ownership stakes of the large, passive asset managers might boost competition, but it would undercut the cheapest and most effective investment strategy available to retail investors. Forcing asset managers to be entirely hands-off, on the other hand, might also boost competition, but neuter shareholder oversight of management.
Yet despair is premature. Common ownership is not the only barrier to competition in the American economy. Corporate giants are all too good at buying up troublesome rivals and lobbying for privileges. As evidence of the side-effects of growth in passive funds accumulates, the best remedy might be for Washington to take its antitrust responsibilities more seriously.
“Hidden power of the big three? Passive index funds, re-concentration of corporate ownership and new financial risk”, Jan Fichtner, Eelke Heemskerk and Javier Garcia-Bernardo, August 2016.
“Anti-competitive effects of common ownership”, José Azar, Martin Schmalz and Isabel Tecu, Ross School of Business Paper No. 1235, July 2016.
“Common ownership, competition and top management incentives”, Miguel Anton, Florian Ederer, Mireia Gine and Martin Schmalz, Ross School of Business Paper No. 1328, Augugst 2016.