The rise of index funds as the biggest shareholders of many companies raises some important questions.
Concerns have been raised over the years that index funds and ETFs are doing strange things to the economy.
The basic model for how companies behave is that they are aiming to maximise profits. They are forced to do so due to their goal of boosting shareholder value. Shareholders want to see the value of their holdings increase and punish firms that do not act in profit-maximising ways.
How exactly firms should do this is always subject to debate. It may be through cutting prices to take market share from competitor firms. It may be investing in new equipment or technology to allow them to produce their product cheaper. Or it may be by investing in research to improve or invent a new product. Either way, shareholders, in theory, usually encourage such behaviour as a way of increasing the value of the company and therefore their holdings.
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This has potential wider benefits for the economy. For example, lower prices to undercut a competitor reduces prices for consumers. Meanwhile, investing in new research or technology can result in exciting new products with wider spillover benefits (the iPhone, for example). Even spinning off part of a business, with the proceeds being paid as dividends, can be beneficial if it means that the capital is cycled into other parts of the economy where it may be more productive.
This model assumes that the interests of shareholders determines how companies behave. This in turn determines the wider performance and health of the economy. With this relationship so vital to our understanding of how capitalism functions, the rise of passively managed index funds as the biggest shareholders of many companies raises some important questions.
Every so often, some of these fears start to appear in the more mainstream press. Recently The Atlantic, a popular US politics magazine, ran an article by Annie Lowreywhich raised many of the longstanding concerns about the rise of passive investing. The article explained the fears of market instability that ETFs may be causing. It also made the point that companies with passive funds as their primary shareholders are changing how they behave.
The article explained: “A far bigger concern is that the rise of the indexers might be making American firms less competitive, through ‘common ownership’, in which the mega-asset managers control large stakes in multiple competitors in the same industry.”
A commonly cited example of common ownership is US airline companies. But generally, the article says, “name an industry with a significant number of publicly traded firms — auto, retail, fast food, agribusiness, telecom—and the same is likely to be true”. And this common ownership, some academics fear, is potentially changing the behaviour of firms.
Lowrey explains: “Let’s imagine that you are a major shareholder in a public widget company. We’d expect you to desire - insist, even - that the company fight for market share and profits. But now imagine that you are a major shareholder in all the important widget companies. You would no longer really care which one succeeded, particularly not if one company doing better meant another company doing worse.
“You’d just care about the widget sector’s corporate profits, which would go up if the widget companies quit competing with one another and started raising prices to pad their bottom line.”
Whether this actually happens is hotly disputed. It seems unlikely that Larry Fink, the chief executive of BlackRock, calls up widget companies and tells them to stop competing with each other on price. Although perhaps they do not need to – management simply knows and understands that their shareholders are less interested in competition than before.
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As noted, the idea is disputed. One of the leading academics in the area is José Azar from the University of Navarra, who has published papers documenting a decline in price competition among airlines in the US due to index fund-induced common ownership.
Other academic research has also tried to show that passive investing is harming the economy in other ways. Most recently, a new paper titled “Common Ownership and the Decline of the American Worker,” by Zohar Goshen and Doron Lev tries to link the rise of passive investing to wage stagnation in the US.
The authors summarise their work as follows: “The last forty years have seen two major economic trends: wages have stalled despite rising productivity, and institutional investors have replaced retail shareholders as the predominant owners of the American equity markets. A few powerful institutional investors - dubbed common owners - now hold large stakes in most US corporations.
“It is not a coincidence that at the same time American workers got a new set of bosses, their wages stopped growing, and shareholder returns went up.”
This is all interesting and important stuff. But what does it mean for investors? Should investors care?
Investors certainly should care in the sense that these are real economic trends. Ultimately, over the long term, the performance and nature of the economy determines the returns on different assets.
But this economic trend is different from others. This is a trend in which investors themselves are part of the problem through their shift away from active to passive strategies. So if – and it is a big ‘if’ still, as it is far from agreed or certain – passive investing is harming the economy, do investors have some sort of obligation to invest in a different way?
My answer: no. If passive investing is damaging the US economy, that’s for policymakers to address. Passive investing has been a boon to investors. Whatever negative externalities that arise from this should be dealt with at the policy level – whatever that entails. The investor’s obligation is to their portfolio, not to position assets in a way most favourable to the economy’s performance.
A good way to think about this is with savings and the so-called paradox of thrift. As economist John Maynard Keynes argued, one person’s spending is another’s income. Therefore, when you save rather than consume, that is money not going into the pocket of others and circulating around the economy.
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In developed economies, people saving too much and not spending enough can hold back the economy. That is, if we all decide together to do the ‘sensible’ thing and save rather than spend, we will collectively be poorer.
But does this factor into our thinking on personal finances? From a personal perspective, would you spend rather than save to help the economy? No – no one thinks of themselves as having an obligation or duty to spend to boost aggregate demand. If you deem saving the best option for your own personal financial situation, you do so.
Likewise, when it comes to investing, you do what is best for achieving your financial goals. My view is that investing in index funds and ETFs, right now, seems like one of the best options for long-term investors. So, while we should be interested in and follow any research looking at the possible harm index funds cause the wider economy, we shouldn’t let it change how we invest.
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