Index Funds Don’t Hurt Consumers, But Monopolies Do
Critics of passive investing blame the wrong thing for higher prices in some industries.
Bloomberg, May 14, 2019
It’s clearer than ever that the actively managed mutual-fund industry, after 75 years of dominance, has succumbed to competition from low-cost indexing. There’s no one to blame but the funds themselves: They charge investors a lot more for inferior performance, which goes a long way toward explaining the multi-trillion dollar shift in how Americans invest their money.
This disruption has been driven largely by the recently deceased Jack Bogle and Vanguard Group, along with BlackRock Inc., State Street Corp. and others. My Bloomberg colleague Eric Balchunas has looked at the total cost savings of indexing, and calculated that the plunge in fees charged for investment-management services, otherwise known as the Vanguard effect, 1 has saved investors about $1 trillion in fees.
Entrenched interests profiting from the status quo has been unwilling to give up that much revenue without a fight. And so active-investing advocates warn us that low-cost indexing is “worse than Marxism,” is “devouring capitalism” or is “lobotomized investing.” The litany of complaints doesn’t end there: Passive investing is “distorting market liquidity,” creating a “mania,” and is a “frightening risk” to markets; indexers “ignore fundamentals,” and are “terrible for our economy.”
Judging by money flows, none of these critiques have carried much weight with investors.
Last week’s Morningstar Investment Conference served as a reminder and is the jumping-off point for today’s discussion. Barron’s reviewed a panel session with the title “Are Index Funds Eating the World?” University of Chicago law school professor Eric Posner argued that “the concentration of ownership, particularly by the Big Three indexers, BlackRock, Vanguard Group, and State Street, can hurt consumers.”
It’s pretty hard to see the justification for this claim. The three intensely competitive fund managers he cited fight for market share and customers, driving costs for consumers to almost nothing — and in some case cases, to nothing at all. And didn’t we just note that indexing has saved investors $1 trillion?
Posner argues that competition among companies creates a strong incentive for innovation, lower prices and better service. But then he pivots: Because these public companies are partly owned by the same big index fund companies, eventually we will see less pressure to compete and innovate. The reason is that big shareholders benefit when companies can keep their prices high, not when they engage in cutthroat price competition.
Posner cites the airline and banking sectors as examples of where prices have gone up as “common ownership” 2 has increased.
Here’s one big problem with Posner’s analysis: he cited two industries that have seen notable price increases while ignoring the reasons those prices rose.
Let’s start with the airline industry. During the past 15 years, the 10 major U.S. airlines have been merged into four carriers, eliminating unprofitable and non-viable rivals. This has indeed reduced competition 3 and has led to price increases.
This is exactly what the textbooks say we should expect.
Consolidation in the banking industry, especially since the financial crisis, has been even more dramatic. In 1990, the five largest U.S. banks held less than 10% of industry assets; by 2000, it had doubled to more than 20%; as of last year, the five biggest banks held nearly half of all assets in America. What’s driven this industry concentration? Blame bank rescues and shotgun marriages, but more importantly an easing of regulations that since the 19th century had imposed inefficiency and fragmentation on America’s banking industry. Once those regulations were lifted the result was mergers and acquisitions, reduced competition and increased prices.
And what was passive indexing’s role in this process? Posner doesn’t identify it, but I can: precisely zero.
Another problem with Posner’s argument is that it ignores industries where prices have gone down, such as software, toys, automobiles, household furnishings, mobile-phone services, technology and clothing. These companies have had the same increase in index-fund ownership as banks and airlines, and in many cases they have had increased market concentration — and yet their prices have fallen.
The other question that isn’t addressed is that for indexers to have encouraged anticompetitive behavior would have required them to engage in a criminal conspiracy to restrain trade and fix prices. Yet no one even tries to make this assertion, nor is there any evidence that investigators have uncovered anything like it.
To accept the Posner thesis one would have to believe Vanguard, BlackRock and State Street are going to throw out their investment philosophy, ignore their fiduciary obligations to their investors and risk vast reputational harm so that some of the thousands of companies they hold a stake in can raise prices and reduce competition.
Long before indexing became popular, many actively managed mutual funds held the same companies. Recall the popular “Nifty Fifty” stocks of the 1960s, which every money-management firm of that era seemed to own? And yet, no evidence of anticompetitive activity has been found to have been caused by having similar large fund ownership back then.
Market concentration may very well be a problem for the economy in some industries, causing harm to consumers. But researchers, analysts and critics of index investing would be providing a much more valuable service by critiquing America’s lax antitrust regime of the past 30 years than the money-saving brainchild of Jack Bogle.
_______
1. The Vanguard effect is so significant that it actually has measurable impact on inflation.
2. The phrase “common ownership” is both misleading and seems to imply something nefarious. These companies are not owned in-common or jointly, as is suggested by that phrase. In the future, I plan to use the more precise phrase “index ownership” or “index membership” to more accurately represent how these companies are held.
3. According to the Economist: “Air fares are higher per seat mile in America than in Europe. When costs fall, consumers in America fail to enjoy the benefits. The global price of jet fuel—one of the biggest costs for airlines—has fallen by half since 2014. That triggered a fare war between European carriers, but in America ticket prices have hardly budged. Airlines in North America posted a profit of $22.40 per passenger last year; in Europe the figure was $7.84.”
Previously:
Why Would Indexers Become Anti-Competitive Monopolists? (May 14, 2019)
Index funds Are the Root of All Evil (December 19, 2018)
Active Management (various)
~~~
I originally published this at Bloomberg, May 14, 2019. All of my Bloomberg columns can be found here and here.
