I wrote yesterday about what I think is a congealing regulatory view that index funds are Good and should be encouraged, and that active management is Bad and should be discouraged, but here is a wonderful mad corrective from Eric Posner and E. Glen Weyl at Slate, calling on Congress to ban index funds:
Another approach would be for Congress to pass a law that restricts the holdings of mutual funds and other institutional investors. The law would be very simple. Currently, employees and employers get tax advantages when employers set up retirement accounts for employees. The government regulates the types of funds that employers may offer to their employees. The government should direct employers to offer only mutual funds that do not own a significant number of shares of more than one firm in a specific industry. In other words, mutual funds would be allowed to own shares of only a single firm in any specific industry, but could invest in as many industries as they wanted.
So it’s not just index funds; diversified actively managed funds would also face restrictions, though “By owning shares in different industries, mutual funds could continue to offer the diversification benefits that investors value them for.” Index funds, though, which by definition own all the companies in all the industries, would be off limits in this regime, at least in retirement accounts.
So … why? Posner and Weyl are riffing on this paper by José Azar, Martin C. Schmalz and Isabel Tecu, finding, according to its title, “Anti-Competitive Effects of Common Ownership.” Azar, Schmalz and Tecu look at the airline industry, where a good percentage of the shares of many big airlines are owned by overlapping groups of big mutual funds (not necessarily index funds). They argue that this common ownership reduces competition, finding “that ticket prices are approximately 3-5% higher on the average US airline route than would be the case under separate ownership.” A possible explanation for this finding is that mutual funds that own lots of shares in all of the airlines don’t really push any one airline to cut prices to compete hard against the other airlines: Cutting margins to gain market share might work for one airline, but for the airlines as a group it drives down profits. And airlines’ shareholders own airlines as a group, not individually.
This doesn’t necessarily need to be an explicit conspiracy. Azar, Schmalz and Tecu:
A more benign – and likely – interpretation of our results is that owners generally need to push their firms to aggressively compete, because managers will otherwise enjoy a “quiet life” (Bertrand and Mullainathan, 2003) with little competition and high margins. Only shareholders with undiversified portfolios have an incentive to engage to that effect, while only large shareholders have enough clout to do so. However, the largest shareholders of most firms tend to have diversified portfolios and therefore reduced incentives to push for more competition, whereas smaller undiversified investors don’t have the power to change firm policy without the support of their larger peers. It is important to realize again that it is both unlikely and unnecessary that shareholders give their portfolio firms explicit directions with respect to the desired intensity of competition in particular markets.
Diversified investors are less likely to push for price wars than those whose fortunes are tied to a single competitor, and managers are less likely to start price wars if they’re not pushed.
Going from that conclusion to banning diversified mutual funds is a bit of a stretch. I tweeted about Posner and Weyl’s article and the reactions were, I think it is fair to say, uniformly incredulous. Josh Barro pointed out that ”airlines seem like a bad example of anticompetitive pricing, since they go bankrupt all the time.” More generally, people seemed horrified by the argument that the government should try to limit indexing and diversification.