Mike Sykuta and I have been blogging about our recent paper on so-called “common ownership” by institutional investors like Vanguard, BlackRock, Fidelity, and State Street. Following my initial post, Mike described the purported problem with institutional investors’ common ownership of small stakes in competing firms.
As Mike explained, the theory of anticompetitive harm holds that small-stakes common ownership causes firms in concentrated industries to compete less vigorously, since each firm’s top shareholders are also invested in that firm’s rivals. Proponents of restrictions on common ownership (e.g., Einer Elhauge and Eric Posner, et al.) say that empirical studies from the airline and commercial banking industries support this theory of anticompetitive harm. The cited studies correlate price changes with changes in “MHHI?,” a complicated index designed to measure the degree to which common ownership encourages competition-softening.
We’ll soon have more to say about MHHI? (admirably described by Mike!) and the shortcomings of the airline and banking studies. (Look for a “Problems With the Evidence” post.) First, though, a few words on why the theory of anticompetitive harm from small-stakes common ownership is implausible.
Common ownership critics’ theoretical argument proceeds as follows:
- Premise 1: Because institutional investors are intra-industry diversified, they benefit if their portfolio firms seek to maximize industry, rather than own-firm, profits.
- Premise 2: Corporate managers seek to maximize the returns of their corporations’ largest shareholders—intra-industry diversified institutional investors—and will thus pursue maximization of industry profits.
- Premise 3: Industry profits, unlike own-firm profits, are maximized when producers refrain from underpricing their rivals to win business.
Ergo:
- Conclusion: Intra-industry diversification by institutional investors reduces price competition and should be restricted.
The first two premises of this argument are, at best, questionable.
With respect to Premise 1, it is unlikely that intra-industry diversified institutional investors benefit from, and thus prefer, maximization of industry rather than own-firm profits. That is because intra-industry diversified mutual funds tend also to be inter-industry diversified. Maximizing one industry’s profits requires supracompetitive pricing that tends to reduce the profits of firms in complementary industries.
Vanguard’s Value Index Fund, for example, holds around 2% of each major airline (1.85% of United, 2.07% of American, 2.15% of Southwest, and 1.99% of Delta) but also holds:
- 1.88% of Expedia Inc. (a major retailer of airline tickets),
- 2.20% of Boeing Co. (a manufacturer of commercial jets),
- 2.02% of United Technologies Corp. (a jet engine producer),
- 3.14% of AAR Corp. (the largest domestic provider of commercial aircraft maintenance and repair),
- 1.43% of Hertz Global Holdings Inc. (a major automobile rental company), and
- 2.17% of Accenture (a consulting firm for which air travel is a significant cost component).
Each of those companies—and many others—perform worse when airlines engage in the sort of supracompetitive pricing (and corresponding reduction in output) that maximizes profits in the airline industry. The very logic suggesting that intra-industry diversification causes investors to prefer less competition necessarily suggests that inter-industry diversification would counteract that incentive.
Of course, whether any particular investment fund will experience enhanced returns from reduced price competition in the industries in which it is intra-industry diversified ultimately depends on the composition of its portfolio. For widely diversified funds, however, it is unlikely that fund returns will be maximized by rampant competition-softening. As the well-known monopoly pricing model depicts, every instance of supracompetitive pricing entails a deadweight loss—i.e., an allocative inefficiency stemming from the failure to produce units that create greater value than they cost to produce. To the extent an index fund is designed to reflect gains in the economy generally, it will perform best if such allocative inefficiencies are minimized. It seems, then, that Premise 1—the claim that intra-industry diversified institutional investors prefer competition-softening so as to maximize industry profits—is dubious.
So is Premise 2, the claim that corporate managers will pursue industry rather than own-firm profits when their largest shareholders prefer that outcome. For nearly all companies in which intra-industry diversified institutional investors collectively hold a significant proportion of outstanding shares, a majority of the stock is still held by shareholders who are not intra-industry diversified. Those shareholders would prefer that managers seek to maximize own-firm profits, an objective that would encourage the sort of aggressive competition that grows market share.
There are several reasons to doubt that corporate managers would routinely disregard the interests of shareholders owning the bulk of the company’s stock. For one thing, favoring intra-industry diversified investors holding a minority interest could subject managers to legal liability. The fiduciary duties of corporate managers require that they attempt to maximize firm profits for the benefit of shareholders as a whole; favoring even a controlling shareholder (much less a minority shareholder) at the expense of other shareholders can result in liability.
More importantly, managers’ personal interests usually align with those of the majority when it comes to the question of whether to maximize own-firm or industry profits. As sellers in the market for managerial talent, corporate managers benefit from reputations for business success, and they can best burnish such reputations by beating—i.e., winning business from—their industry rivals. In addition, most corporate managers receive some compensation in the form of company stock. They maximize the value of that stock by maximizing own-firm, not industry, profits. It thus seems unlikely that corporate managers would ignore the interests of stockholders owning a majority of shares and cause their corporations to refrain from business-usurping competition.
In the end, then, two key premises of common ownership critics’ theoretical argument are suspect. And if either is false, the argument is unsound.
When confronted with criticisms of their theory of anticompetitive harm, proponents of common ownership restrictions generally point to the empirical evidence described above. We’ll soon have some thoughts on that. Stay tuned!