Even if institutional investors’ common ownership of small stakes in competing firms did cause some softening of market competition—a claim that is both suspect as a theoretical matter and empirically shaky—the policy solutions common ownership critics have proposed would do more harm than good.
Einer Elhauge has called for public and private lawsuits against institutional investors under Clayton Act Section 7, which is primarily used to police anticompetitive mergers but which literally forbids any stock acquisition that substantially lessens competition in a market. Eric Posner, Fiona Scott Morton, and Glen Weyl have called on the federal antitrust enforcement agencies (FTC and DOJ) to promulgate an enforcement policy that would discourage institutional investors from investing and voting shares in multiple firms within any oligopolistic industry.
As Mike Sykuta and I explain in our recent paper on common ownership, both approaches would create tremendous decision costs for business planners and adjudicators and would likely entail massive error costs as institutional investors eliminated welfare-enhancing product offerings and curtailed activities that reduce agency costs.
The touchstone for liability under Elhauge’s Section 7 approach would be a pattern of common ownership that caused, or likely would cause, market prices to rise. Elhauge would identify suspect patterns of common ownership using MHHI∆, a measure that assesses incentives to reduce competition based on, among other things, the extent to which investors own stock in multiple firms within a market and the market shares of the commonly owned firms. (Mike described MHHI∆ here.) Specifically, Elhauge says, liability would result from “any horizontal stock acquisitions that have created, or would create, a ∆MHHI of over 200 in a market with an MHHI over 2500,” if “those horizontal stock acquisitions raised prices or are likely to do so.”
The administrative burden this approach would place on business planners would be tremendous. Because an institutional investor can’t directly control market prices, the only way it could avoid liability would be to ensure either that the markets in which it was invested did not have an MHHI greater than 2500 or that its acquisitions’ own contribution to MHHI∆ in those markets was less than 200. MHHI and MHHI∆, though, are largely determined by others’ investments and by commonly owned firms’ market shares, both of which change constantly. This implies that business planners could ensure against liability only by continually monitoring others’ activities and general market developments.
Adjudicators would also face high decision costs under Elhauge’s Section 7 approach. First, they would have to assess complicated econometric studies to determine whether adverse price effects were actually caused by patterns of common ownership. Then, if they decided common ownership had caused a rise in prices, they would have to answer a nearly intractable question: How should the economic harm from common ownership be allocated among the investors holding stakes in multiple firms in the industry? As Posner et al. have observed, “MHHI∆ is a collective responsibility of the holding pattern” in markets in which there are multiple intra-industry diversified investors. It would not work to assign liability only to those diversified investors who could substantially reduce MHHI∆ by divesting, for oftentimes the unilateral divestment of each institutional investor from the market would occasion only a small reduction in MHHI∆. An aggressive court might impose joint liability on all intra-industry diversified investors, but the investor(s) from whom plaintiffs collected would likely seek contribution from the other intra-industry diversified investors. Denying contribution seems intolerably inequitable, but how would a court apportion damages?
In light of these administrative difficulties, Posner et al. advocate a more determinate, rule-based approach. They would have the federal antitrust enforcement agencies compile annual lists of oligopolistic industries and then threaten enforcement action against any institutional investor holding more than one percent of the stock in such an industry if the investor (1) held stock in more than one firm within the industry, and (2) either voted its shares or engaged firm managers.
On first glance, this enforcement policy approach might appear to reduce decision costs: Business planners would have to do less investigation to avoid liability if they could rely on trustworthy, easily identifiable safe harbors; adjudicators’ decision costs would fall if the enforcement policy made it easier to identify illicit investment patterns. But the approach saddles antitrust enforcers with the herculean task of compiling, and annually updating, lists of oligopolistic industries. Given that the antitrust agencies frequently struggle with the far more modest task of defining markets in the small number of merger challenges they file each year, there is little reason to believe enforcers could perform their oligopoly-designating duties at a reasonable cost.
Even greater than the proposed policy solutions’ administrative costs are their likely error costs—i.e., the welfare losses that would stem from wrongly deterring welfare-enhancing arrangements. Such costs would result if, as is likely, institutional investors were to respond to the policy solutions by making one of the two changes proponents of the solutions appear to prefer: either refraining from intra-industry diversification or remaining fully passive in the industries in which they hold stock of multiple competitors.
If institutional investors were to seek to avoid liability by investing in only one firm per concentrated industry, retail investors would lose access to a number of attractive investment opportunities. Passive index funds, which offer retail investors instant diversification with extremely low fees (due to the lack of active management), would virtually disappear, as most major stock indices include multiple firms per industry.
Moreover, because critics of common ownership maintain that intra-industry diversification at the institutional investor level is sufficient to induce competition-softening in concentrated markets, each institutional investor would have to settle on one firm per concentrated industry for all its funds. That requirement would impede institutional investors’ ability to offer a variety of actively managed funds organized around distinct investment strategies—e.g., growth, value, income etc. If, for example, Southwest Airlines were a growth stock and United Airlines a value stock, an institutional investor could not offer both a growth fund including Southwest and a value fund including United.
Finally, institutional investors could not offer funds designed to bet on an industry while limiting exposure to company-specific risks within that industry. Suppose, for example, that a financial crisis led to a precipitous drop in the stock prices of all commercial banks. A retail investor might reasonably conclude that the market had overreacted with respect to the industry as a whole, that the industry would likely rebound, but that some commercial banks would probably fail. Such an investor would wish to invest in the commercial banking sector but to hold a diversified portfolio within that sector. A legal regime that drove fund families to avoid intra-industry diversification would prevent them from offering the sort of fund this investor would prefer.
Of course, if institutional investors were to continue intra-industry diversification and seek to avoid liability by remaining passive in industries in which they were diversified, the funds described above could still be offered to investors. In that case, though, another set of significant error costs would arise: increased agency costs in the form of managerial misfeasance.
Unlike most individual shareholders, institutional investors often hold significant stakes in public companies and have the resources to become informed on corporate matters. They have a stronger motive and more opportunity to monitor firm managers and are thus particularly well-poised to keep managers on their toes. Institutional investors with long-term investor horizons—including all index funds, which cannot divest from their portfolio companies if firm performance suffers—have proven particularly beneficial to firm performance.
Indeed, a recent study by Jarrad Harford, Ambrus Kecskés, & Sattar Mansi found that investment by long-term institutional investors enhanced the quality of corporate managers, reduced measurable instances of managerial misbehavior, boosted innovation, decreased debt maturity (causing firms to become more exposed to financial market discipline), and increased shareholder returns. It strains credulity to suppose that this laundry list of benefits could similarly be achieved by long-term institutional investors that had no ability to influence managerial decision-making by voting their shares or engaging managers. Opting for passivity to avoid antitrust risk, then, would prevent institutional investors from achieving their agency cost-reducing potential.
In the end, proponents of additional antitrust intervention to police common ownership have not made their case. Their theory as to why current levels of intra-industry diversification would cause consumer harm is implausible, and the empirical evidence they say demonstrates such harm is both scant and methodologically suspect. The policy solutions they have proposed for dealing with the purported problem would radically rework an industry that has provided substantial benefits to investors, raising the costs of portfolio diversification and enhancing agency costs at public companies. Courts and antitrust enforcers should reject their calls for additional antitrust intervention to police common ownership.