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Stepan Lavrouk
Articles (172) 

Are Index Funds Bad For Corporate Governance?

When all companies are owned by the same people competition might suffer

May 12, 2019
Anyone who has picked up a financial news source in the last few decades knows that index funds have had an enormously transformative effect on the investment industry. Consensus has been steadily growing that passively managed funds outperform active management by a significant margin. Warren Buffett (Trades, Portfolio) famously won a $1 million bet (donated to charity) a few years ago that the S&P 500 would outperform a basket of hedge funds selected by an asset manager.

The success of index funds, coupled with their ultra-low fees, has forced active managers to lower their own, meaning that even those who choose active over passive have benefitted. The “two and twenty” fee structure, once practically ubiquitous amongst hedge funds, is going out of fashion. Investors just aren’t comfortable paying out 2% of their assets, on top of a 20% performance fee, especially when the returns do not always outperform index funds. So in short, index funds have changed a lot of things.

But what about corporate governance? What happens when a handful of large institutional investors owns competing companies? Might this have a chilling effect on competition? Well, as it turns out: it’s complicated.

Common ownership creates an incentive to collude

Taken at face value, it’s not actually that unreasonable to argue that common ownership of competing companies might result in anti-competitive behaviour. After all, we certainly frown on the idea of a single individual, or even a single company owning an entire industry. Why should index funds be any different? Shareholders want to see their investments doing well, all of them. This means that there are incentives to encourage companies in the same industry to operate in a way that benefits shareholders, but is detrimental to consumers (for instance, by keeping prices artificially high).

Now, this may sound like a tinfoil hat theory, and it is probably a little extreme to suggest that fund managers are phoning up boardrooms and giving them explicit instructions to engage in anti-competitive behaviour. However, that doesn’t mean that these incentives don’t have an effect on decision-making on the margins. And, as argued in a recent paper in the Washington Law Review, institutional investors are more than happy to advertise the pressure they exert on fossil fuel companies to curb production in order to fight climate change. Would it really be so strange for them to also do so to keep oil prices high?

Another side to the story?

However, not everything is so simple (as mentioned above: it’s complicated). There are also reasons to believe that index investing, which has extended ownership of publicly-traded companies to a wider range of people, has had beneficial effects for competition. If you own all companies in an industry, you may not care if one happens to do poorly - the others will just pick up the slack.

Moreover, there is an case to be made that it has improved financial disclosure, which most people would agree is a good thing. However, there is also an argument that increased disclosure actually has anti-competitive effects, as it allows public companies to signal their strategies to competitors and collude, without actually calling each other up to do so. If there is no gun there is no crime.

One thing is certain, however: the dynamics of company ownership are changing in very profound ways, and the full effect of these changes will only be properly evaluated many years in the future.

Disclosure: The author owns no stocks mentioned.

About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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