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Rekenthaler Report

There’s No Need to Regulate Index Funds

Nipping a bad idea in the bud.

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Business Squabbles
Traditional investment managers have disliked index funds ever since they were introduced. Understandably so. Index funds not only drastically undercut the industry’s pricing, thereby threatening its profitability, but they also implicitly denigrate active management. After all, index funds only thrive if most active managers cannot beat their benchmarks, after costs.

Indexing’s attack has led to 40 years of sniping from active managers. Buying an index fund, they state, means settling for mediocrity. Or, all index funds are losers, since after expenses they trail their benchmarks. Indexing creates stock-market bubbles, because index funds invest mindlessly, without regard for valuations. Indexing distorts security prices, inflating the prices of stocks held by the major indexes, while depressing those of the outsiders.

So far, so good. Those arguments weren’t much good, but they remained outside the courtroom. Nobody filed lawsuits, or sought regulatory changes. The battle between the incumbent investment managers and the upstart indexers was waged in the business world. To the victor went the spoils.

Is Competition Insufficient?
A recent academic paper, “Anti-Competitive Effects of Common Ownership,” by Jose Azar, Martin Schmalz, and Isabel Tecu, has levied a new attack on indexing. It makes the bolder and more-damaging claim that indexers harm society. Index funds, they say, encourage CEOs to behave as semi-monopolists, while overpaying themselves.

That paper quickly attracted attention, being the right paper for the right time. The U.S. currently offers two major economic puzzles:

  1. Why have almost 10 years’ worth of consistently low interest rates (and quantitative easing) not triggered inflation?
  2. Why do U.S. corporate profit margins set new highs each year?

The authors answer the second of those two great questions.

The paper's thesis: In large part, profit margins have become elevated because a handful of huge index-fund providers own everything. All the major U.S. companies. Such “common ownership,” as the authors term it, discourages competition. Index funds don’t want their CEOs to fight, because one company’s gain becomes another’s loss. They want their CEOs to coexist peacefully, by implicitly (if not explicitly) colluding so that their prices remain high, and the wages they pay to labor are low.

Legal Matters
The authors are far more confident of their findings than I am. Their argument is very broad, and their evidence indirect. (This column describes their thesis in more detail, and outlines my qualms.) However, an influential law professor, Eric Posner of the University of Chicago, has accepted their hypothesis as fact, and has gathered some attention by proposing a solution: Break up the index funds.

Posner proposes “restrictions on mutual fund investment within industries.” Specifically, he writes (with co-author Glen Weyl, also a Chicago law professor):

“We don’t oppose all mutual funds, just those that cartelize industries. Mutual funds that buy shares of firms across industries, rather than within industries, get a pass. The gains from further diversification within industries after the benefits from diversification across industries, are tiny. Moreover, small funds can buy shares within industries without harming anyone.”

In other words, Posner would ban the index fund as we know it, unless it came from a small provider. Vanguard, BlackRock, State Street … the industry leaders would no longer be permitted to index by scooping up all companies in an industry, or even perhaps more than one. If you own  Coca-Cola (KO), you can’t own  PepsiCo (PEP). Posner has been adept at spreading the word, including with this op-ed article from The New York Times.

Bogle’s Counter
Jack Bogle, unsurprisingly, has been displeased. In addition to disputing the underlying argument, that Vanguard and other major fund families somehow encourage (or at least cast a blind eye upon) bad corporate behavior, he points out the practical difficulties in enforcing such a ban.

First, there would be major tax consequences for investors for the existing index funds to unwind their positions, to conform to the new regulation. Second, who gets  Amazon (AMZN)? Or  Apple (AAPL)? Imagine running an index fund, and you aren’t permitted to own the year’s single best-performing stock—but your rival was. That would be most unpleasant.

Bogle’s response is reasonable. Perhaps the academic claim is correct; that could be so. However, the subject is too complex, and the paper too speculative, for the common-ownership thesis to be anything other than an initial thought. The evidence is not strong enough to change the laws. And yes, the practical implications are daunting.

Corralling the Chiefs
All that makes sense, but I would take Bogle’s reasoning one step further. Assume for argument’s sake that the professors’ allegations are indeed true: Common ownership, as exemplified by Vanguard’s massive index funds, has eroded stock-market stewardship. Let’s also accept as fact that negligent fund companies have permitted—perhaps even encouraged—CEOs to operate against society’s best interest.

If that is so, then surely the legal remedy should be applied to the guilty party: CEOs. The analogy is of a burglar who commits his crime after being encouraged by his friends, who have dared him to be brave and do something wicked for once. They should not have said those words. But the primary legal penalties for theft accrue to the wrongdoer, not to the influences. And rightly so. Want to stop a leak? Plug the source.

How CEO behavior might be changed, via the legal system, is beyond the scope of this column. However, I can offer a couple of ideas. One solution, suggested by others, would be a stronger executive branch. Have the Department of Justice actively enforce the existing antitrust laws. More than a century ago, Teddy Roosevelt put teeth into the Sherman Antitrust Act, with good effect. Perhaps that spirit should be resurrected.

Another approach, which to my knowledge has not been advanced elsewhere, is legislative. At heart, the complaint about the conduct of CEOs involves incentives. Corporate chiefs are currently rewarded for profitability, as manifested by stock-price performance. So, change the rules on compensation. Require that CEOs be rewarded instead for growing market share. Or, perhaps, on relative stock price, such that if their company’s stock gained 30% on the year, and the industry average was 35%, they are judged to have failed.

It may be protested that such solutions are unnecessarily extreme. And breaking up index funds would not be? At any rate, nothing need be done now—not without further study. But if, after additional research, CEOs are found to be poorly motivated, with index funds bearing some of that responsibility, there is still no good reason to regulate index funds. Corral the chief perpetrators instead.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.