For example, Azar, Schmalz, and Tecu
(2017) conclude that the government should
restrict institutional investors from owning
competing firms if the anticompetitive effects
of common ownership are not outweighed
by the efficiency-enhancing effects of
diversification. Others have already suggested
policy responses to concentrated ownership,
most notably Posner, Morton, and Weyl
(2017), who would restrict asset managers
from owning more than one company in
a competitive industry.
This debate may seem academic, but it may find
a receptive audience among politicians,
at least among Democrats. With the release
of their Better Deal policy document, Democratic
politicians signaled they plan on running for
election in 2018 on a campaign of breaking up
unpopular monopolies (albeit without yet naming
large asset managers as a target).
As these ideas jump from economics and legal
literature to policymaking, policymakers will need
a framework for evaluating whether the potential
costs of concentrated ownership are, in fact,
greater than the benefits. As Azar et al. conclude,
“Which effect prevails is an empirical question
that goes beyond the scope of our paper,
which merely intends to start the debate.” This
short column will not answer the question
of which effect prevails, either, but it seeks
to ascertain the key questions that policymakers
need to ask to develop a framework.
The Benefits of Index Funds
Dramatic changes could be required to eliminate
any anticompetitive effects of common ownership
of competing companies. For example, Posner
et al. explore a few solutions before concluding
that an institutional investor should own
no more than one company in a potentially
uncompetitive industry unless the investor owns
less than 1% of the market share.
Further, the paper argues that no institutional
investor should communicate with top
managers or directors of such a firm. (According to
Posner et al., a potentially uncompetitive industry
is one where a few large companies do
not compete for market share. They call this
an oligopoly and define it using a mathematical
formula for competition, although they
envision regulators would have discretion
to designate oligopolies.)
This novel approach has the potential to
dramatically change the operations of index funds;
it could fundamentally turn them into active
stock-pickers. After all, active funds constrained
from owning, say, multiple airline companies could
continue to use the tools of active ownership to
determine in which airline to invest. So,
the rule, while a constraint, does not alter the
value proposition of an active fund the way it does
a passive fund.
To quantify the costs of such a change,
policymakers first need to understand how many
people benefit from index funds. More than
50% of Americans have retirement savings
accounts. Changing one of the key innovations
in retirement investing over the past 30 years
directly affects 57 million households, according
to our analysis of the Survey of Consumer
Finances. In short, such a shift would not
only affect a small number of institutional investors
profiting from concentrated holdings in
leading companies but also many Americans
saving for retirement.
Another critical question is the importance
to investors of the diversification that common
ownership provides. Common ownership
is a necessary byproduct of diversifying in a single
fund. If a fund has the goal of providing
broad ownership of the stock market to achieve
diversification, it is necessarily going to hold
shares in competing companies. Posner
et al. cite Campbell, Lettau, Malkiel, and Xu (2001),
who argue that the volatility of not diversifying
across companies can be mitigated by diversifying
across industries. But how robust is this
finding over time? Presumably, some investors
will end up investing in the airline, bank, or
technology company that doesn’t perform well
or is driven out of business by competitors.
Will this create a “longer tail” of failed retirement
accounts by increasing the idiosyncratic risk
retirement savers and other investors take on in
their investments? Indeed, Morningstar has found
that most returns earned by investors can
be attributed to the growth of the upper 20%
of successful companies—growth many investors
would miss if they were in funds forced
to choose among leading companies, rather
than owning several leaders in a broadly
Posner et al. argue that passive funds could
randomly select companies within an industry and
that investors could hold multiple funds with
overlapping strategies to mitigate this problem.
But this would have large ramifications for
the retirement-plan market. Employers who offer
401(k) plans would have to offer new options
and explain to employees how to use them.
There also likely would be risks that such a novel
approach would violate fiduciary principles.
Further, asset managers would lose the economies
of scale that have led to steadily decreasing
costs for investors.
Which leads to another question: How broad
are the benefits of index funds beyond their
reduced costs for people who invest in them?
Index funds have forced active funds to justify
their higher fees and explain their strategies. They
have put plan sponsors and IRA advisors under
pressure to ensure they recommend active funds
whose fees they can justify to their clients.
Indeed, the asset-weighted average expense ratio
for all funds fell to 0.57% in 2016, down from
0.61% in 2015 and 0.65% three years ago,
according to Morningstar’s latest fees study
(Oey 2017). The asset-weighted average fees for
passive funds and active funds are 0.17% and
0.72%, respectively, according to our fees study.
If index funds could no longer operate as
they have, but had to pick which companies to
invest in, what would the ripple effects be for
investors? Keep in mind that the low costs of index
funds are directly related to their simplicity.
Add another layer of stock selection to the process
of indexing, and investors can expect fees
to go up.
Other Explanations for Abnormal Profitability
In terms of the anticompetitive effects of
common ownership, how strong is the available
evidence, and where can we look for other
proofs? What other explanations might there be for
the abnormal profitability of publicly traded
companies we have seen? And how can we drill
down to the total costs of these anticompetitive
effects, if there indeed are any?
As you’ll read in this issue’s Spotlight
section, Morningstar’s analysts have found
evidence as to why companies have
become abnormally profitable recently. There are
more wide-moat companies today than in
the past. These firms operate in industries with
a high barrier to entry and, thus, can charge
higher prices. Or maybe, U.S. industries
have become less competitive as fewer publicly
traded companies compete against each other.
(Such a problem suggests more traditional
In other words, there is not conclusive evidence
that asset managers with too much concentrated
ownership are the problem—yet. That does
not mean this could not become a problem in the
future. I merely mean that we don’t have
enough evidence to link the cause of higher-than-normal
profitability to the anticompetitive
effects of asset managers owning large shares of
competing companies, rather than to other trends.
Finally, to properly perform a cost-benefit analysis
on restricting mutual funds from common
ownership of competing firms, we would need
a clear empirical estimate of the costs to
consumers. In the airline industry, Azar et al.
estimate common ownership costs consumers an
extra 3% to 7% in ticket prices. But what about
other industries? And Azar’s airlines estimate
is a wide range. The two ends of the range
(3% and 7%) might yield different answers to a
cost-benefit analysis, given the importance
of index funds to a broad range of ordinary
Break Up Index Funds?
It seems unlikely that U.S. policymakers are
going to act on any of these ideas now, but that
might change the next time Democrats are
ascendant. A key centerpiece of their plan is the
“Better Deal on Competition and Costs,” which
promises to “crack down on corporate monopolies.”
There are two big reasons this line of argument will
make for appealing rhetoric in the midterm
elections and beyond. First, as income and wealth
inequality has grown, there is a growing belief
that the system is rigged, so running against
monopolies is a good way to align that feeling with
Second, antitrust action allows politicians to talk
about increasing equality without arguing
for massive new bureaucracies, raising taxes, or
redistributing resources in obvious ways.
The Better Deal plan does not mention asset
managers but focuses instead on the usual
suspects: airlines and cable and telecom
companies, along with less-frequently talked about
industries such as breweries and commercial
agricultural seed companies—examples that seem
crafted to appeal to Americans living in the
heartland. However, most legislation tends to give
broad statutory authority to regulators, who
can fill in the details later.
In this case, should the Better Deal plan turn into
legislation and eventually law, it would create
a new consumer competition advocate, with
broad authority to keep markets fair and open.
Given the academic literature on common
ownership among asset managers of competing
companies, this could pave the way to new,
novel forms of antitrust action, effectively ending
broad index funds, thus raising the costs
(and lowering the returns) of ordinary investors.
Furthermore, high-profile Democratic senators
(Cory Booker, Amy Klobuchar, Kirsten Gillibrand,
and Al Franken, among others) are taking
the idea seriously and recently introduced a bill
(S. 1811) that would require the Federal
Trade Commission to study whether common
ownership of companies by asset managers
Evidence Needed Before Action
None of this is to say we should not treat
arguments about concentrated ownership
seriously. As the great political theorist Albert O.
Hirschman argued in The Rhetoric of Reaction
people opposed to policy reforms have
argued for centuries that a reform will perversely
result in the opposite effect of what policymakers
wish or jeopardize a positive status quo.
The questions raised in this article could be viewed
as an endorsement of the status quo. On the
other hand, we prefer to err on the side of
the known advantages of index funds, as opposed
to the putative gains from their disruption,
until there is more evidence to resolve the key
questions around the costs and benefits of
a policy response.
Azar, J., Schmalz, M., & Tecu, I. 2017. “Anti-
Competitive Effects of Common Ownership,” Journal
of Finance, forthcoming.
Campbell, J.Y., Lettau, M., Malkiel, B.G., & Xu, Y. 2001.
“Have Individual Stocks Become More Volatile?
An Empirical Exploration of Idiosyncratic Risk,” The Journal
of Finance, Vol. 56, No. 1, February, pp. 1–43.
Oey, P. 2017. “U.S. Fund Fee Study,” Morningstar Manager
Research white paper, May 23.
Posner, E., Morton, F.S., & Weyl, E.G. 2017. “A Proposal
to Limit the Anti-Competitive Power of Institutional
Investors,” Antitrust Law Journal, forthcoming.
This article originally appeared in the December/January 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.