Mike Sykuta and I have been blogging about our new paper responding to scholars who contend that institutional investors’ common ownership of small stakes in competing firms significantly reduces market competition and should be restricted. (FTC Commissioner Noah Phillips cited the paper yesterday in his excellent prepared remarks on common ownership.) Mike first described the purported competitive problem. I then set forth some problems with the anticompetitive theory common ownership critics have asserted.
When confronted with criticisms of their theory, common ownership critics have pointed to the empirical evidence Mike mentioned. In the most high-profile study, researchers correlated changes in commercial air fares with changes in “MHHI∆”, an index designed to measure the degree to which common ownership has reduced the incentive to compete. They concluded that common ownership has increased airfares by three to seven percent. A similar study of the commercial banking industry correlated banking fees and interest on deposit accounts with “GHHI”, a metric similar to MHHI∆. That study concluded that common ownership has led to higher fees and lower interest rates for depositors.
Common ownership critics have treated these studies as a trump card. The authors of the airline study, for example, brushed off a criticism of their anticompetitive theory with the following retort: “This argument falls short of explaining why, empirically, taking into account shareholders’ economic interests does help to explain firms’ product market behavior.”
Of course, to demonstrate “empirically” that institutional investors’ “economic interests” influence their portfolio companies’ “product market behavior” (i.e., cause the companies to charge higher prices, etc.), researchers would need to (1) correctly identify institutional investors’ economic interests with respect to their portfolio firms’ product market behavior, and (2) establish that those interests cause firms to act as they do. On those crucial tasks, the airline and banking studies fall short.
In assessing institutional investors’ economic interests, the studies have assumed that if an institutional investor reports holding a similar percentage of each firm in a market—say, five percent of the stock of each major airline—then it must have an “economic interest” in maximizing industry rather than own-firm profits. Such an assumption is unwarranted. That is because each institutional investor’s reported holdings, set forth on forms it must submit under Section 13(f) of the Securities Exchange Act, aggregate its holdings across all its funds. Such aggregation paints a misleading picture of the institutional investor’s actual economic interest.
For example, while Vanguard’s Section 13(f) filing reports ownership of a similar percentage of American, Delta, Southwest, and United Airlines—suggesting an economic interest in industry profit maximization—the picture looks very different at the individual fund level:
- Vanguard’s Value Index Fund (VIVAX) holds significant stakes in American, Delta, and United (0.46%, 0.45%, and 0.42%, respectively) but holds no Southwest stock. VIVAX does best if United, American, and Delta usurp business from Southwest.
- Vanguard’s Growth Index Fund (VIGRX) holds a significant stake in Southwest (0.59%) but holds no stake in American, Delta, or United. Investors in VIGRX would prefer that Southwest win business from American, Delta, and United.
- Vanguard’s Mid-Cap Index Fund (VIMSX) and Mid-Cap Value Index Fund (VMVIX) hold significant stakes in United (1.00% and 0.321%, respectively) but hold no stock in American, Delta, or Southwest. Investors in VIMSX and VMVIX would prefer that United win business from American, Delta, and Southwest.
- Vanguard’s PRIMECAP Core Fund (VPCCX) holds stakes in all four major airlines, but its share of Southwest (1.49%) is twice its share of American (0.72%), nearly four times its share of United (0.38%), and seven-and-a-half times its share of Delta (0.198%). Investors in VPCCX would prefer that Southwest grow at the expense of American, United, and Delta. They would also prefer that American win business from United and Delta, and that United win business from Delta.
We could go on, but the point should be clear: Because returns to retail investors in the funds of Vanguard and similar institutions turn on fund performance, the competitive outcome that maximizes retail investors’ profits will differ among funds.
Proponents of restrictions on common ownership might respond that even if an institutional investor’s individual funds have conflicting preferences, the institutional investor as an entity must have some preference about whether to maximize industry profits or the profits of a particular company. Because it cannot honor all its individual funds’ conflicting preferences with respect to competitive outcomes, the institutional investor will settle on the compromise strategy that maximizes its individual funds’ aggregate returns: industry profit maximization. Such a strategy would be the first choice of the institution’s funds holding relatively equal shares of all firms within a market. And, while the first choice of the institution’s funds that are disproportionately invested in one firm would be to maximize that firm’s profits, those funds would do better with industry profit maximization than with the first-choice strategy of other of the institution’s funds, i.e., those that are disproportionately invested in a different firm.
But even if maximization of industry profits leads to the greatest aggregate returns for an institutional investor’s funds, such a strategy may not be the best outcome for the institutional investor itself. An institutional investor typically wants to maximize its profits, which will grow as it attracts retail investors into its funds versus those of its competitors and steers those investors toward the funds that earn it the greatest profits (fees less costs). To assess an institutional investor’s preferences with regard to the returns of its different funds, then, one must know (1) the degree to which each fund’s attractiveness vis-à-vis rivals’ similar funds turns on portfolio returns, and (2) the profit margin each fund delivers to the institutional investor.
For funds tracking popular stock indices, portfolio returns play little role in winning business from rival fund sponsors. (For example, higher returns on the stocks in the S&P 500 are unlikely to attract investors to BlackRock’s S&P 500 index fund over Fidelity’s or Vanguard’s.) Moreover, the fees charged on such funds, and thus the institutional investor’s potential profit margins, are extraordinarily low. For actively managed funds, portfolio returns are far more significant in attracting investors, and management fees are higher. The upshot is that an institutional investor, in determining what competitive outcome it prefers, will attach little weight to the competitive preferences of passive index funds and more weight to the preferences of actively managed funds, with that weight growing as the funds provide the institutional investor with higher profit margins.
It is quite possible, then, for an intra-industry diversified institutional investor to prefer a competitive outcome other than the maximization of industry profits, even if industry profit maximization would maximize the aggregate returns of its individual funds. Consider, for example, an institutional investor that offers funds similar to the following Vanguard funds:
- Vanguard’s 500 Index Fund (VFIAX) holds near equivalent interests in American, Delta, Southwest, and United and would thus do best with a strategy of industry profit maximization. Its expense ratio (annual fees divided by total fund amount) is 0.04 percent.
- Vanguard’s Value Index Fund (VIVAX) holds similar stakes in American, Delta, and United but does not hold Southwest stock. Its expense ratio is 0.18 percent.
- Vanguard’s PRIMECAP Core Fund (VPCCX) holds a much higher stake in Southwest than in the other airlines and has an expense ratio of 0.46 percent, 2.5 times as great as the no-Southwest VIVAX fund and 11.5 times as high as the fully diversified VFIAX fund.
- Vanguard’s Capital Opportunity Fund (VHCAX) holds significantly higher shares of Southwest and United (1.74% and 1.55%, respectively) than of Delta and American (0.65% and 1.16%, respectively). Its expense ratio is 0.38, more than twice as great as the no-Southwest VIVAX fund and 9.5 times the fully diversified VFIAX fund.
This institutional investor’s Southwest-heavy funds (those resembling Vanguard’s VPCCX and VHCAX funds) charge much higher fees than its fully diversified index fund (the one resembling VFIAX, for which fund returns are unimportant) and significantly higher fees than its funds that are more heavily invested in airlines besides Southwest (those resembling VIVAX). Thus, despite being intra-industry diversified at the institutional level, this institutional investor may do best if Southwest maximizes own-firm profits.
The point here is that discerning an institutional investor’s actual economic interest requires drilling down to the level of its individual funds, something the common ownership studies have not done. Thus, contrary to the assertion of the airline study’s authors, the common ownership studies have not shown “empirically” that “taking into account shareholders’ economic interests does help to explain firms’ product market behavior.” Indeed, they have never established what those economic interests are.
Even if institutional investors’ aggregated holdings accurately revealed their economic interests with respect to competitive outcomes, the common ownership studies would still be deficient because they fail to show that those economic interests caused portfolio firms’ “product market behavior.” As explained above, the common ownership studies employ MHHI∆ (or a similar measure) to assess institutional investors’ interests in competition-softening. They then correlate changes in that metric with changes in portfolio firms’ pricing behavior. The problem is that MHHI∆ is itself affected by factors that independently influence market prices. It is thus improper to infer that changes in MHHI∆ caused changes in portfolio firms’ pricing practices; the pricing changes could have resulted from the very factors that changed MHHI∆. In other words, MHHI∆ is an endogenous measure.
To see why this is so, consider the three-step process involved in calculating MHHI∆ (which Mike described). The first step is to assess, for every coupling of competing firms in the market (e.g., Southwest/Delta, United/American, Southwest/United, etc.), the degree to which the controlling investors in each of the firms would prefer that it avoid competing with the other. The second step considers the market shares of the two firms in the coupling to determine the competitive significance of their incentives not to compete with each other. (The idea is that reduced head-to-head competition by bit players matters less for overall market competition than does reduced competition by major players.) The final step is to aggregate the effect of common ownership-induced competition-softening throughout the overall market by summing the softened competition metrics for each coupling of competitors within the market.
Given this process for calculating MHHI∆, there are at least two sources of endogeneity in the metric. One arises because of the second step. To assess the significance to market competition of any two firms’ incentives to reduce competition between themselves, the market shares of those two firms must be incorporated into the metric. But factors that influence market shares may also influence market prices apart from any common ownership effect.
Suppose, for example, that five institutional investors hold significant and equal stakes (say, 3%) in each of the four airlines servicing a particular air route and that none of the airlines has another significant shareholder. The air route at issue is subject to seasonal demand fluctuations. In the low season, the market is divided among the four airlines so that one has 40% of the business and the other three have 20% each. The MHHI∆ for this market would be 7200. When the high season rolls around, demand for flights along the route increases, but the leading airline is capacity constrained, so additional ticket sales go to the other airlines. The market shares of the airlines in the high season are equal: 25% each.
On these facts, the increase in demand causes MHHI∆ to rise from 7200 to 7500. But the increase in demand is also likely to raise ticket prices. We thus see an increase in MHHI∆ that correlates with an increase in ticket prices, but the price change is not caused by the change in MHHI∆. Instead, the two changes have a common, independent cause.
Endogeneity also creeps in during the third step in calculating MHHI∆. In that step, the “cross MHHI∆s” of all the couplings in the market—the metrics assessing for each coupling the extent to which common ownership will cause the two firms to compete less vigorously—are summed. Thus, as the number of firms participating in the market (and thus the number of couplings) increases, the MHHI∆ will tend to rise. While HHI (the market concentration measure) will decrease as the number of competing firms rises, MHHI∆ (the measure of common ownership pricing incentives) will increase.
For example, suppose again that five institutional investors hold equal stakes (say, 3%) of each airline servicing a market and that the airlines have no other significant shareholders. If there are two airlines servicing the market and their market shares are equivalent, HHI will be 5000, MHHI∆ will be 5000, and MHHI (HHI + MHHI∆) will be 10000. If a third airline enters and grows so that the three airlines have equal market shares, HHI will drop to 3333, MHHI∆ will rise to 6667, and MHHI will remain constant at 10000. If a fourth airline enters and the airlines split the market evenly, HHI will fall to 2500, MHHI∆ will rise further to 7500, and MHHI will again total 10000.
This is problematic, because the number of participants in the market is affected by consumer demand, which also affects market prices. In the market described above, for example, the third or fourth airline might enter the market in response to an increase in demand, and that increase might simultaneously cause market price to rise. We would see, then, a price increase that is correlated with, but not caused by, an increase in MHHI∆; increased demand would be the cause of both the higher prices and the increase in MHHI∆.
In the end, then, the empirical evidence of competition-softening from common ownership is not the trump card proponents of common ownership restrictions proclaim it to be.