An op-ed in The New York Times today lays out the case for imposing new restrictions on how index funds operate. The rationale, according to the authors, is to prevent the reduction in competition in industries that is a direct consequence of indexing.
If the proposal is implemented as outlined, the indexing strategy for equity investing that’s widely practiced could be headed for extinction.
At issue is the tendency of index funds to hold large stakes of several companies within industries in order to replicate an index, such as the S&P 500(NYSEARCA:SPY). For example, there are five airline stocks in the S&P 500. In order to properly track this index, it’s necessary to hold all five stocks in the relevant weights, based on current market capitalization. It’s standard operating procedure for indexing, but it’s also the basis for reducing competition and raising prices, write Eric Posner, a professor at the University of Chicago Law School; Fiona Scott Morton, a former deputy assistant attorney general for economics at the antitrust division of the Department of Justice and a professor at the Yale School of Management; and Glen Weyl, a visiting scholar in economics and law at Yale.
“The problem is not just the size of the institutional investors, but the way they invest,” the authors charge. “Institutional investors often own stakes in all the competitors in concentrated industries.”
This concentration, we’re told, leads to higher prices for consumers.
The empirical impact of institutional investors was revealed in two blockbuster academic papers. One — written by José Azar, Martin C. Schmalz and Isabel Tecu — found that airline ticket prices increased as much as 10 percent because of common ownership. Another — by Mr. Azar, Mr. Schmalz and Sahil Raina — found large increases in bank fees and reductions in interest rates to savers from common ownership of banks.
The op-ed authors note that a legal solution already exists, if only the government would enforce it.
Such [anti-competitive via index-fund] ownership patterns are already illegal. Section 7 of the Clayton Antitrust Act makes firms that buy stock in other firms liable if “the effect of such an acquisition may be substantially to lessen competition, or to tend to create a monopoly.” In 1957 the Supreme Court noted that such prohibitions hold “even when the purchase is solely for investment.” Unfortunately, because the antitrust implications of institutional investment were not recognized until recently, legal action has not yet been taken.
The downside to all of this is that reordering the rules for how index funds operate would reduce and perhaps eliminate the consumer-friendly advantages of these investment products. Indeed, expense ratios for some large index funds are just a few basis points, which is to say nearly zero. The expense ratio for the S&P 500-tracking Vanguard 500 Index Fund Admiral Class (VFIAX), for instance, is just 0.05%–a small fraction of what many actively managed US equity funds charge.
The authors of the op-ed recognize the value that indexing offers to the investing public and in a bid to preserve the advantage they recommend that a new push to enforce the Clayton Act should carve out a safe harbor provision for index funds that limit investments in stocks in certain industries or hold just one representative stock in an industry. As an example, Posner and company advise that indexers “could own a large stake in United or Delta or American or Southwest, but not all of them.”
Large institutional investors could still provide cheap, diversified mutual funds to consumers under our proposal because the benefits of diversification within an industry are tiny compared with diversification across industries. A fund owning United Airlines can diversify with holdings in Walgreens; it does not need to own Delta as well. Small institutional investors can diversify in any way they like.
The bottom line, the authors argue, is that “our proposal would restore competition to our increasingly cartelized economy with a minimum of disruption for existing business practices.
Perhaps, but imposing the restrictions they outline could upend indexing as currently practiced. In turn, tracking error would probably rise and effectively destroy the ability to closely replicate certain indexes. Imagine a world where a government entity issues rules on which stocks in the S&P 500 an index fund can hold, or not, and you’ll have a sense of what may be coming if the op-ed’s recommendations are put into practice.
Consider banking stocks. According to Wikipedia, the S&P 500 includes 14 banks. In fact, most industry groups with representation in the S&P include multiple companies—17 health care equipment firms, for example.
The question is whether the added complexity of meeting new government standards for investing would effectively kill indexing as we know it? If the answer is Yes, would that reduce or even eliminate the generally advantageous indexing proposition that’s been immensely beneficial for the investing public over the last 40 years? Possibly.
The counterargument is that a new framework for quasi-passive investing could emerge that manages the delicate balancing act of preserving the best aspects of indexing while satisfying government regulations on investing. Maybe, but this sounds like a recipe for trouble relative to the efficiency and success of indexing as currently practiced.
At the moment, there’s no discernible push in Washington to reorder the ground rules for indexing. Could that change with the incoming Trump administration? The answer may depend on how much populist zeal drives the agenda.
Meantime, let’s carefully consider the pros and the cons of attempting to reinvent indexing on the public’s behalf. The first order of business is asking independent researchers to verify (or reject?) the conclusions in the two studies cited in the op-ed. Is the average consumer really suffering from higher fees and prices because of indexing? Even after factoring in the lower fees and higher average performance (relative to actively managed funds) that’s par for the course with indexing?
Indexing isn’t perfect, but in the grand scheme of financial innovation over the last half century it’s clear that the rise of passive investing has benefited the investing public on a grand scale. What isn’t clear is that trying to reinvent the wheel by way of government regulation is destined for maintain, much less improve, this enviable track record.