Are Large Passive Funds Discouraging Competition?
The data do not support a causal story.
Over the past few years, a group of economists and law professors has made a provocative argument: Large index funds discourage competition among the companies they own, hurting consumers. If this is true, this "common ownership" problem suggests policymakers should engage in a hugely disruptive response, by either curbing the size of asset managers that invest in competing companies or limiting their ability to diversify within the same industry. Recently, these ideas have jumped from the academic to the policy realm. In fact, the Federal Trade Commission recently held a daylong hearing and requested public comment on proposed remedies to this problem.
Could Mutual Funds' Common Ownership Hurt Competition?
But first, let's take a step back: What is common ownership, and what are the effects that academics and policymakers are worried about? Common ownership refers to the phenomenon of asset managers acquiring large stakes of several companies within the same industry (for example, a passive fund that tracks the S&P 500 will necessarily buy shares in American (AAL), Delta (DAL), Southwest (LUV), and United (UAL)).
This common ownership could lead to negative outcomes for consumers, the argument goes. As asset managers acquire increasingly large stakes of publicly traded companies that compete within the same industry, they have an incentive to lean on those companies and encourage them not to compete as much. This, in turn, causes consumers to pay higher prices than they otherwise would if companies were fiercely competing for their money. These higher prices paid by consumers manifest in "abnormal profitability," a term of art that basically means that some firms are enjoying higher markups than previously seen.
There's no doubt that both common ownership and higher profits are on the rise. Common ownership is a manifestation of passive and index investing, which has seen explosive growth over the past 20 years. Higher profits are a little harder to measure, but there is consensus among economists that firms are increasingly reaping the benefits of abnormal profitability.
The theory that common ownership leads to anticompetitive outcomes seems compelling at first blush, but upon closer examination, we don't think it holds up under scrutiny.
Could Common Ownership Cause Abnormal Profitability? The Timing Isn't Right
Morningstar's data show no obvious link between common ownership and abnormal profitability. If we accepted the theory that common ownership increased pressure on firms to engage in anticompetitive practices, then we would expect the flow to passive funds to precede higher markups and margins: Common owners would have to first build up a large stake in firms before they exercised their influence to discourage competition and increase markups. However, the graph below does not bear out this story. Instead, we see profit margins increasing prior to flows toward passive funds increasing and remaining rather flat after the significant growth of passive funds.
In addition to this basic graphical analysis, we ran a few more sophisticated analyses using time-series methods. In particular, we wanted to see if operating margins could be better predicted using the history of both operating margins and assets under management in passive funds--also known as Granger causality. Our analysis did not find evidence of Granger causality, which implies that operating margins are not particularly affected by flows to passive funds. This, too, runs counter to the theory that there is a causal link between common ownership and higher profit margins. These are two processes that are independent of each other.
An Alternative Explanation: More Moats, More Profits
Earlier this year, Morningstar's policy research team submitted a comment letter to the Federal Trade Commission in response to its request for information on common ownership. In short, we expressed our skepticism about the causal link between common ownership and anticompetitive practices. In addition to the empirical evidence stacked against it, the theory relies on some rather heroic assumptions. For example, that managers at companies would be more responsive to a single shareholder who owns, say, 5% of the company's stock rather than the remaining 95% of diverse shareholders seems a bit of a stretch. Furthermore, senior management compensation packages are often tied clear targets such as revenue, so their incentives are clearly misaligned with a common owner's incentives.
Instead, we think that rising profit margins are driven by other forces. The proliferation of wider moats is one possible explanation. Wider moats insulate a company from rising costs and competition. A study by Morningstar found that more companies are building increasingly wider moats than before. In 1987, 35 of the 100 largest firms would have earned a Morningstar Economic Moat Rating of wide, and by 2017, that number grew to 57.
It is true that passive funds have grown enormously over the past 20 years, at a time when profits have been unusually high. However, the assumptions necessary to establish a causal link between common ownership and abnormal profitability seem unrealistic, and the data don't bear out what we would expect if common ownership caused abnormal profitability. Instead, we see these two trends as secular and occurring independent of one another.
Aron Szapiro does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.