A new line of research suggests that diversification across stocks in an industry can reduce competition, but that argument is weak.
By Alex Bryan, CFA | 01-10-18 | 06:00 AM | Email Article

Does common ownership of stocks in the same industry reduce competition? That is the central question that an emerging body of academic research is seeking to address. While this research is still in its early stages and the evidence is inconclusive, the policy reactions it might elicit could be significant for investors.

Alex Bryan, CFA, is director of passive strategies for North America at Morningstar.

Some proposals have suggested limiting an asset manager's holdings to one stock in each industry where its ownership stake in a firm exceeds 1%, which would effectively ban large index funds, and preventing asset managers that own two or more competitors from exercising their voting rights. (Morningstar's Aron Szapiro explains why these policy recommendations are problematic in his article, "Would Policymakers Target Index Funds?") But the underlying argument that common ownership leads to less competition relies on some misguided assumptions.

At the heart of this argument is the idea that shareholders who own multiple firms in the same industry (common owners) have an incentive to maximize industry profits, rather than individual firm profits. So, they behave in ways that concentrated investors wouldn't, by not pressuring managers to compete aggressively, or otherwise using their influence to discourage competition and boost industry profits. Jose Azar (an economist at IESE Business School) and his colleagues developed this argument in two studies (1, 2) that found that an increase in common ownership in the airline and banking industries was associated with higher prices for the services those firms offered.

Consider the U.S. airline industry, which is dominated by  Southwest ,  Delta ,  American , and  United . Imagine one investor buys up all four companies, which is effectively a merger. Clearly, that owner could exercise operational control over the combined entity and would raise prices on the routes where the independent firms previously competed. The common ownership argument predicts that there would be a similar anticompetitive effect when investors hold minority stakes in competing companies.

While this argument can be used against any large investor who owns more than one stock in the same industry, it is particularly problematic for index managers, since they mechanically own all the stocks in an index and are often among the largest owners of these stocks. Their influence will keep growing as assets continue to shift from actively managed to index funds.  

Flawed Assumptions
For the common ownership argument to work, four things must be true:

1) Firms with common owners would be more profitable individually if they competed more aggressively than they are currently.

2) Corporate managers don't have proper incentive to act in their own firm's best interest.

3) Managers prioritize common owners' interests over other shareholders.

4) Common owners apply less pressure on managers to deliver strong performance than investors who only own one stock in an industry (concentrated investors).   

Only the last assumption is credible--at least for institutional investors. Because the other three are not, common ownership should have no bearing on competitive behavior or consumer prices.

It is not always in a firm's individual interest to compete more aggressively because actions designed to take market share away from competitors, like price cuts and cutting-edge innovation, often elicit a competitive response that could hurt profits. For example, if American Airlines cuts fares on a route, its competitors will likely follow suit, leaving American (and its competitors) in a less profitable position. When it is not in a firm's individual interest to compete more aggressively, the mix of common and concentrated investors should have no effect on firm behavior because these investors' interests would be aligned--both groups would prefer less competition. That doesn't mean that firms behave the same as they would if they were part of a cartel, just that they wouldn't necessarily compete more aggressively if common owners were out of the picture.  

As long as managers have incentive to maximize their own firm's value--as most are--an increase in common ownership shouldn't lead to less competitive behavior. It is a stretch to presume that a firm would compete less aggressively to help its competitors, if doing so meant sacrificing its own profitability. Corporate managers are going to do whatever they think will maximize their own wealth, even if common owners aren't applying as much pressure for them to do that as concentrated investors.

Corporate managers' fiduciary obligation extends to all their shareholders. So, even if common owners have a vested interest in reducing competition in a manner that is inconsistent with maximizing the value of the firm, it isn't clear that managers would favor their interests over shareholders who don't own any of the firm's competitors. Doing so would violate the firm's fiduciary obligations.

A More Holistic View
Suppose that the common ownership argument is accurate: That index (and other diversified asset) managers look the other way while firms adopt less competitive behavior to increase industry profits. It isn't necessarily in asset managers' interest to do that. Rather, if they were able to affect how companies competed with one another, it would be in their interest to use that influence to maximize the value of their entire portfolios. That means they would favor their larger holdings over their smaller holdings, and might even benefit from greater competition (and lower prices) in some industries whose goods and services are expenses for their holdings in other industries. Take the energy industry, for example. Energy stocks represent less than 6% of  Vanguard Total Stock Market ETF , but energy prices affect most companies' expenses. Greater competition in this sector might be better for index investors than less. The banking and airline papers ignore these cross-industry effects.

With this in mind, it isn't obvious that index managers would benefit much at all from oligopolistic behavior in the airline industry. Airline stocks represent a small fraction of most index funds (less than 0.5% of VTI), and yet travel expenses impact most publicly traded companies. Higher ticket prices especially hurt the hotel, restaurant, and leisure industry, which represents a larger portion of most indexes than the airline industry. This demonstrates that the net effects of less competition and higher prices in one industry aren't necessarily beneficial for diversified asset managers.  

What About the Airline and Banking Industries?
The papers that documented a positive relationship between common ownership and prices in the airline and banking industries shouldn't be dismissed outright. But more empirical evidence is needed to establish that greater common ownership causes higher prices, and that they don't just happen to move together. It is difficult to isolate the impact of common ownership on competition because there are many factors at work.

It is also important to note that both papers relied on limited data. The airline paper examined data from 2001 through 2014, while the banking paper included data from 2003 through 2014. Both industries experienced considerable consolidation over these periods. Also, many airlines emerged from bankruptcy during this span and have since taken a more rational approach to pricing. The findings may well be valid, but we should reserve judgment until the analysis can be applied to more industries and markets over longer periods with appropriate controls.

Don't Kill Index Funds
It is a bad idea to act on the emerging research suggesting that common ownership of stocks in the same industry reduces competition, leading to higher prices. That argument rests on some questionable assumptions, and it is difficult to empirically isolate the impact of common ownership on competitive behavior. Even if an increase in common ownership led to less competition, it makes more sense to address it through traditional antitrust actions than by placing onerous limits on diversification that would effectively dismantle large index funds, or voting rights.

Index funds have provided enormous benefits to millions of investors. To justify taking those benefits away, common ownership would need to have a big impact on competitive behavior: Much bigger than the 3%-7% price impact that the airline paper found. A harsh policy response is unlikely under the Trump administration but could become a bigger threat in the future. 

References
1) (Airline Paper) Azar, J., Schmalz, M.C., & Tecu, I. 2017. "Anti-Competitive Effects of Common Ownership." Journal of Finance. Working Paper (March): https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2427345

2) (Banking Paper) Azar, J., Raina, S., & Schmalz, M.C. 2016. "Ultimate Ownership and Bank Competition." IESE Business School. Working Paper (July): https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2710252

 

 

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