Eric Posner is professor of law at the University of Chicago. Among his research interests is the question of the increasing concentration of ownership in corporate America, including the role of institutional investors.
I know who Vanguard is. I know who BlackRock is. But there are a lot of financial companies I’ve never heard of and that maybe I’d be nervous about giving them my money.
A recent paper he co-wrote with Microsoft economist Glen Weyl and Yale University economics professor Fiona Scott Morton proposes limiting the companies an index fund can own in one industry. Posner spoke to Morningstar’s global head of research, Haywood Kelly, and director of policy research, Aron Szapiro.
Haywood Kelly: You argue that under current antitrust law, claims could be made against companies like Vanguard and BlackRock. How does antitrust law apply here?
Posner: It’s illegal for investors to buy shares of companies if the effect of the purchases would be anticompetitive. If you or I buy shares of McDonald’s (MCD) or some shares in a fund, we’re not going to have any effect on competition.
But if it’s an institutional investor that already has a large stake in rival companies within a concentrated market and it increases those stakes, and if one can show empirically that the effect of those purchases is to reduce competition among the underlying firms, then you’ve met that standard.
One of the major defences is something called the passive investor defence. It says if you are passive – if you are just buying shares because you want to enjoy a share of the profits, but you don’t plan to control the company – then you are not violating the law, because if you are not exerting any control of the company, you are not going to have any anticompetitive effect. The institutional investors will argue that they fall within this passive investor exception.
There are other sorts of complications and questions, but antitrust law is a flexible area of the law
Kelly: Given that there are papers from economists on both sides of this issue, how would that affect the legal process?
Posner: There are some papers that have been written that I just don’t think are nearly as strong as the papers on our side.
It’s very unlikely that someone is just going to sue all the institutional investors for all the anticompetitive effect they have had on the whole economy. Such a claim is just too broad and vague. What might happen is that someone might bring a lawsuit against institutional investors solely for their effect on the airline industry or for their effect on banking. Those could be separate lawsuits.
Kelly: Is there enough evidence to bring such lawsuits?
Posner: Yes. I believe that the plaintiffs would have a strong case, and for that reason, it’s just a matter of time before somebody brings a lawsuit. There has always been a lot of litigation against the airlines for all kinds of stuff, all kinds of anticompetitive behaviour, and it’s just a matter of time before the plaintiffs bring in the institutional investors and argue that they are either implicitly or explicitly coordinating the airlines.
Kelly: Our view, given the trends in the industry toward passive and scale advantages of the likes of Vanguard and BlackRock, is that this will only become more of an issue over time, making it more likely that policymakers will get involved.
There’s no reason to think that their ownership is going to flatten out or go down. There’s every reason to think it will continue to increase. Part of the reason it will continue to increase, of course, is that people are finding index funds more and more appealing.
Kelly: One of your proposals is to restrict ownership to, say, one company within a concentrated industry, as opposed to spreading it out.
Posner: This problem is not something for which there is a clean solution. There are lots of different solutions. I think litigation is the natural solution. But the worry is, it’s going to create a huge mess because litigation is unpredictable.
What would rules look like that might address this problem? The rule we came up with was this idea that – to simplify it – you can have big institutional investors, but they would be allowed to own only one firm per industry. Or you can have small institutional investors who could be fully diversified; they can own all the firms in one industry, but they just have to have less than a 1% [market] share.
If our rule were put into place, we would predict that the market would segment, and you would see the big institutions like BlackRock divest from all the firms in a concentrated industry except for one and increase the stake in that remaining firm. BlackRock might have, say, 10% of United Airlines and 0% in the other airlines. In the meantime, you could see lots of smaller asset managers who could have 1% in all the airlines.
Kelly: But no matter what the strategy is for diversifying across industries, if you’re only holding one company in each competitive industry, some investors would end up worse off?
Posner: One problem is that people would have to search out and find the small [asset managers – the 1% companies – if they want to be fully diversified. I know who Vanguard is. I know who BlackRock is. But there are a lot of financial companies I’ve never heard of and that maybe I’d be nervous about giving them my money
Or I could stick with Vanguard. I would just be slightly less diversified. Our initial view was that the cost would be low because the amount of diversification an ordinary person gets by owning all the companies within one industry as opposed to companies across industries is very small, because the stock prices of companies within an industry tend to be highly correlated.
If I am just an ordinary person and I want to be fully exposed to the stock market, there is not a whole lot of difference between owning stock in one company per industry as opposed to owning stock in every single company in the market. That’s why the S&P 500 is probably fine for most people. They don’t really need to own stock of 2,000 companies or 10,000 companies. So, mathematically, the additional diversification benefit you get is small.
Kelly: If BlackRock or Vanguard were to concentrate in one company and if their market share continues to grow, you could imagine a case where Vanguard owns a majority or close to a majority of one competitor and BlackRock owns close to a majority stake in another competitor.
Posner: BlackRock or Vanguard might divide. They might become smaller. I don’t see any reason in theory to think that it would be worse, but we wouldn’t know for sure until we entered that world. A lot would depend on what they did. If they continued to be passive, as they claim they are now, there wouldn’t be any anticompetitive effect.
There would be complicated governance issues that would arise. As a legal matter, they might have more responsibility.
Kelly: Do you think that, in addition to the argument around concentrated ownership, the traditional legal tools could yield greater gains to consumers today?
Posner: I’m very much in favour of antitrust litigation. In the United States, the antitrust laws have been interpreted in a more relaxed way than they have been in the distant past, with the result that industries have become more concentrated than they used to be.
You could make the argument that the US Justice Department could just focus on the underlying firms rather than the institutional investors and maybe that would be sufficient if the concentrated markets were broken up. Then ownership by institutional investors would not be a problem. It’s only a problem when the underlying markets are concentrated.
Kelly: What about the reaction among the fund industry?
Posner: They are obviously not happy about this work, but they seem willing to engage. What I’d like to see them do is provide data to independent academics. That would be the best way to settle the various controversies.
I do believe institutional investors when they say that, at least for index funds, they’d like to just be passive. They don’t want to actually have to vote. But on the other hand, the government forces them to, right? They’re not allowed to be passive.
When institutional investors started buying up large chunks of these firms, people argued this could be a good thing, because now you’d have shareholders who are large enough that it would be worth their while to exert control over these corporations. But the problem is that if they also own rival corporations, they may exert the control over these corporations in a way that’s not beneficial to the public.
This article originally appeared in the December/January 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website. A longer version of this article is available here.
