On Index Funds and Anti-competitive Activity

Among the plethora of investment products available, index funds have historically been considered among the more respectable, reliable and generally safe options for investors and markets alike.

Tied to the performance of baskets of stocks, the funds offer broad market exposure and relatively low operating expenses as a result of their passively managed structures. Furthermore, many index funds have offered performance rivaling their actively managed counterparts during selected measurement periods, which in turn makes them appear even more attractive. Investors have increased their allocations to such funds in recent years. Regulators, such as the Department of Labor during the Obama administration, have tended to promote the low fees charged by some index funds amid the heightened focus on comparatively expensive alternative funds, promoted since the 2008 fiscal crisis to dampen, rather than capture, market risk.

Index funds have recently become the focus of a theory that paints a less benevolent picture of their effect on market dynamics. A recent study published by professors of law and economics from Yale University and the University of Chicago explores the extent to which a small group of institutional investors have amassed significant ownership stakes of competing public companies within specific industries. It details how, over the past several decades, various large institutional investors — such as BlackRock, Vanguard and Fidelity — have built up ownerships of between 3%-7% each, typically, in competing companies within an industry. While not alleging any form of collusion, the study suggests the market conditions created by the combined ownership of these funds is significant enough to represent an oligopoly within the specific industry, thereby reducing competition and resulting in higher prices for consumers.

As an example, it examines institutional investors’ ownership of U.S. airline companies, highlighting Berkshire Hathaway’s buy of significant shares in American Airlines, Delta Airlines and United Continental in 2016, in addition to its purchase of an undisclosed stake in Southwest Airlines. It also cites data showing each of the six U.S. airlines studied was minority-owned by a group of institutional investors with a combined stake in that ranged from 25% to 35%. Using the Herfindahl-Hirschman Index, a commonly used tool to measure the effects of a merger on market concentration, the six U.S. airlines studied showed a rating of more than 2,500, out of a maximum 10,000. Significantly, 2,500 is the threshold above which the Federal Trade Commission (FTC) considers a post-merger market to be “highly concentrated,” according to its 2010 Horizontal Merger Guidelines.

The Yale paper posits the potential for anti-competitive outcomes created by such activity, asserting that “the concentration of markets through large institutional investors is the major new antitrust challenge of our time.” Although not alleging a coordinated effort between funds, some proponents of this theory have suggested litigation may be justified, pointing to Section 7 of the Clayton Act, which prohibits mergers and acquisitions that produce an outcome that “may be substantially to lessen competition, or to tend to create a monopoly.” Moreover, whether the investor intends to reduce competition is not relevant — the effect of their actions is what matters, they argue.

The authors of the Yale study propose a regime under which “no institutional investor or individual holding shares of more than a single effective firm in an oligopoly may ultimately own more than 1% of the market share or directly communicate with the top managers or directors of firms.” The authors note the concern that “many mutual funds have sold products to consumers, such as S&P tracking funds, that they could not legally offer at large scale and comply” with this rule. In response, they suggest it be addressed by incorporating “a delay between announcement and implementation,” which could also give firms the chance to close funds and create new products, as needed, in compliance with the new antitrust enforcement policy.

Meanwhile, other academics have examined the potentially negative market impacts of such conditions and recommend that, rather than adding blanket regulations or litigation, a more nuanced approach be adopted that evaluates common stock ownership on a case-by-case basis. Still others have warned of a renewed era of near-monopolies in some industries, the likes of which the U.S. hasn’t seen since the 19th century. While no consensus exists on the level of risk the situation may present nor how to properly respond, the Yale study has sparked a debate about index funds and the role they play in market activity. Despite the call from some quarters for increased regulation or even litigation, the funds remain largely popular among investors and regulators alike.

Representatives of the fund industry challenge the theory, saying it confuses correlation with causation. They identify other factors, such as increasing demand after the 2008 fiscal crisis, that enabled companies in concentrated industries such as airlines to raise prices. David Blass, general counsel of the Investment Company Institute, argues cogently that proposed “solutions” to the tenuous problem “undermine the very concept of index investing” and also deny “active managers their flexibility,” thereby disrupting the interests of the 55 million U.S. households that own mutual funds and the capital markets in which those funds invest.