Harvard professor says index funds should be illegal

[FireLane]

I read this jaw-dropping article today and I don't know whether to laugh or be horrified:

http://www.bloombergview.com/articles/2015-07-22/index-funds-may-work-a-little-too-well

This guy's argument is that index funds encourage anti-competitive behavior. Nowadays, most public corporations' biggest shareholders are institutional investors like Vanguard that aim to own whole market sectors rather than individual companies. And as we know, index funds care about overall profits rather than how any one company does.

This means that if corporate executives want to please their biggest stockholders, they shouldn't compete too hard against each other for market share, since that would require them all to cut prices, which would drive down everyone's profits and would erode the overall value of an index fund. Instead, corporations in the same industry have an incentive to collude, or at least not compete as hard as they can, to keep overall profits high.

On the one hand, that's not totally crazy. I can follow the chain of his logic. On the other hand, that's totally crazy! That would imply that it ought to be illegal for anyone to own shares of two companies in the same industry. It would force all of us to be stock-pickers rather than indexers. It would make the market an even bigger casino than it currently is, and needless to say, it would make a realistic FIRE plan impossible.

I don't think this has any serious chance of passing into law. But it goes to show you can never tell what the future risks might be for a FIRE strategy.

[forummm]

Interesting theoretical argument. I don't think there's much danger of this due to index funds at the current time. But if they were holding 90% of the shares, maybe.

[DavidAnnArbor]

I wish Vanguard and Fidelity would use their power of ownership to actually effect better management at all these companies, lowering executive compensation would be a start.

[milesdividendmd]

I find the argument a bit obtuse, actually.

There is zero evidence that index fund providers are pressuring competitors to be anticompetitive, or even that doing so would be of benefit to their shareholders.

After all if you hold the whole market, then one sector's increased profitability is another's noose (an obvious example of such being big oil and transports.

Cap weighted indexing is the most vanilla and non activist form of investing possible.

This strikes me as the final argument in a losing battle for active investment.

First argument:  passive indexing guarantees "average" returns.

Then indexing is proven to be superior to active management 80% of the time over long time horizons.

Cue the....

Second argument:  save me regulators, index funds are anticompetitive, (despite the complete lack of evidence for this claim.)

[matchewed]

Aren't there bigger anti-competitive issues in corporate America outside of index funds (regardless of if I agree with this dude's premise)?

[sheepstache]

But different index funds weight differently for one thing.

If cutting prices gets you more market share that might make your company worth more in short order which would then mean cap-weighted indexes buy more, yes?

I partially take the point. When the BP oil spill happened, their stock price dropped. Maybe individual investors were disgusted by the environmental impact or maybe they were worried about damage claims and government fines. But a plain vanilla index fund wouldn't have sold. Good for the holders of that index fund as it turns out but also good for BP, though I don't know what they would have done differently if they had been under more pressure.
I might have an imperfect understanding, I'm sure someone can correct me.

[dungoofed]

I have been following this closely. It's very interesting, and I haven't formed a conclusion yet.

Footnote 7 is where the action is, if you're looking for "proof," in particular the link to http://www.bloombergview.com/articles/2015-05-19/passive-investors-and-dominant-bankers

[milesdividendmd]

But different index funds weight differently for one thing.

If cutting prices gets you more market share that might make your company worth more in short order which would then mean cap-weighted indexes buy more, yes?

I partially take the point. When the BP oil spill happened, their stock price dropped. Maybe individual investors were disgusted by the environmental impact or maybe they were worried about damage claims and government fines. But a plain vanilla index fund wouldn't have sold. Good for the holders of that index fund as it turns out but also good for BP, though I don't know what they would have done differently if they had been under more pressure.
I might have an imperfect understanding, I'm sure someone can correct me.

A cap weighted fund does not buy or sell shares based on price movements in particular stocks.  It buys when it has more money under management and sells when it has less and always buys shares in proportion to their cap weight at that time. Incidentally, this is why cap weighted funds are cheap: no rebalancing.

In the BP Oil spill example an index fund would not sell based on bad news, but its weight in in the fund would be decreased in proportion to BPs eventual loss of market capitalization. There is nothing anticompetitive about the role that the index fund plays, it is merely another buy and hold investor that perhaps decreases the overall volatilility in the marketplace.

[forummm]

A cap weighted fund does not buy or sell shares based on price movements in particular stocks.  It buys when it has more money under management and sells when it has less and always buys shares in proportion to their cap weight at that time. Incidentally, this is why cap weighted funds are cheap: no rebalancing.

And minimal transaction costs, no payments to active managers, minimal or no capital gains distributions, etc.

[milesdividendmd]

They pay passive managers, but all the rest stem from the decreased need for transactions (ie no rebalancing.)

[sheepstache]

But different index funds weight differently for one thing.

If cutting prices gets you more market share that might make your company worth more in short order which would then mean cap-weighted indexes buy more, yes?

I partially take the point. When the BP oil spill happened, their stock price dropped. Maybe individual investors were disgusted by the environmental impact or maybe they were worried about damage claims and government fines. But a plain vanilla index fund wouldn't have sold. Good for the holders of that index fund as it turns out but also good for BP, though I don't know what they would have done differently if they had been under more pressure.
I might have an imperfect understanding, I'm sure someone can correct me.

A cap weighted fund does not buy or sell shares based on price movements in particular stocks.  It buys when it has more money under management and sells when it has less and always buys shares in proportion to their cap weight at that time. Incidentally, this is why cap weighted funds are cheap: no rebalancing.

Sure, what I'm saying is if they hit on a successful strategy, like lowering prices (which this guy is saying won't happen), that makes the company better, they get rewarded by more index funds buying their stock, so it's not anti-competitive. You're still getting rewarded for doing a better job. I didn't know it only mattered to purchases and not an adjustment to current holdings, thanks!

The other thing I'm trying to say is that it doesn't make sense that this professor is having this conversation by just referencing some generic index fund since they have different criteria, for example they're not all cap-weighted.

[brooklynguy]

It is an interesting theory.  The classic antitrust concern is that companies can use their monopoly or near-monopoly position to unfairly benefit themselves (to the detriment of consumers).  If a single company or a collection of companies acting in concert is able to corner a market, then, in the absence of antitrust regulation, that company or collection of companies can price gouge, which benefits that company or each of the companies in the collusion (but obviously hurts the consumers in that market).

Here, though, the argument seems to be that companies with sufficiently high overlap in their institutional ownership may each seek to maximize the profits of the entire industry rather than its own profits, even at the cost of sacrificing its own profits.  It is true that such behavior would be in the interest of shareholders whose ownership spans the entire industry, but, in my view, it is absurd to believe that managers would (or do) consciously try to maximize total industry profits by sacrificing the profits of their own company (unlike traditional collusive behavior, where each company participating in the collusion is seeking to maximize its own profits by maximizing the profits of the entire industry or collusion of companies).

Imagine a company's management trying to justify such behavior to its shareholders.  "Yes, we, Coca-Cola, could have competed harder and increased the price of your KO shares, but we didn't because we know you own Pepsi too!"

The underlying premise is that companies may act in the interest of its shareholders, not considered in their capacity as its own shareholders but in light of their broader diversified shareholdings (which is why, the argument goes, companies may seek to maximize total industry value rather than individual company value).  You can extend the premise of this argument to further logical extremes:  after all, companies know that some of its shareholders are customers of the industry too, so why not take those interests into account?  If you zoom out far enough, you will find a common denominator across every shareholder of every company in the world.

[mohawkbrah]

sounds a bit silly saying that index funds eliminate competitiveness. companies will always compete for that dolla dolla bill. because everyone wants to be richer than everyone else.

[tvan]

If shareholders were your only stakeholder this might be valid, but they aren't. 

[adamwoods137]

If shareholders were your only stakeholder this might be valid, but they aren't.

You're confusing how you wish business worked with how it actually works.  Managers attempt to maximize their own profit.  Shareholders elect board members who hire managers to maximize their own profit.  Managers have no direct incentive to be concerned about any other group in and of itself.  Other countries give board seats to other stakeholders besides shareholders.  Maybe this is a preferable way of doing things, but it is not how they are done at this time and place.

[tvan]

If shareholders were your only stakeholder this might be valid, but they aren't.

You're confusing how you wish business worked with how it actually works.  Managers attempt to maximize their own profit.  Shareholders elect board members who hire managers to maximize their own profit.  Managers have no direct incentive to be concerned about any other group in and of itself.  Other countries give board seats to other stakeholders besides shareholders.  Maybe this is a preferable way of doing things, but it is not how they are done at this time and place.

Strong blanket conspiracy statement.

[adamwoods137]

It would make the market an even bigger casino than it currently is, and needless to say, it would make a realistic FIRE plan impossible.

I don't think this has any serious chance of passing into law. But it goes to show you can never tell what the future risks might be for a FIRE strategy.

This doesn't in any way make a FIRE plan impossible.  You could simply roll some dice on the Russel 5000 and buy 100 random companies, additional benefits from diversification are not high.  Even if index funds are banned there will be no US Government v Firelane for randomly choosing investments.

[adamwoods137]

If shareholders were your only stakeholder this might be valid, but they aren't.

You're confusing how you wish business worked with how it actually works.  Managers attempt to maximize their own profit.  Shareholders elect board members who hire managers to maximize their own profit.  Managers have no direct incentive to be concerned about any other group in and of itself.  Other countries give board seats to other stakeholders besides shareholders.  Maybe this is a preferable way of doing things, but it is not how they are done at this time and place.

Strong blanket conspiracy statement.

No conspiracy here.  People respond to incentives.  Ultimately shareholders own the company, and ultimately shareholders call the shots.  My apologies if I was unclear. 

[nobodyspecial]

No conspiracy here.  People respond to incentives.  Ultimately shareholders own the company, and ultimately shareholders call the shots. 

Ultimately people call the shots.
If a CEO decides a share buy back will boost the stock price this quarter, when their bonus or options package is priced - then it doesn't matter what the cost is to the business next year.

Similarly if the shareholder is a HFT system that is only holding the stock for the light travel time between New Jersey and Wall st then they probably don't care who is calling the shots.