ETFs get blamed for a lot of bad stuff. Critics in say that markets are overvalued and it’s all because of ETFs. And if we see a crash or big correction later this year, it’ll be pinned on ETFs. And if you believe the critics, ETFs aren’t just affecting stock markets. They’re also affecting non-financial markets too, and the consumer is allegedly suffering as a result.
What’s the argument?
Before we go any further, we should say that this is a critique of passive ETFs – although the vast majority of ETFs are passive, there are some active ones – and it applies to all passive funds, not just passive ETFs.
The idea is that as passive ETFs buy all the stocks in an index they may end up investing in all the major players in an industry. So in the UK a FTSE 100 ETF would invest in Barclays, Royal Bank of Scotland, Lloyds, HSBC – the UK’s five largest banks. If you were only invested in one of those banks, say HSBC, you might be pleased if an aggressive price war broke out. Sure, HSBC’s profits might be hit in the short term, but if HSBC won the price war, its market share would grow and you’d make more profit in the medium term. If you were an ‘activist’ investor – investors who push for change in a company’s strategy – you might push for the price war to start in the first place.
But if you’re invested in all five banks, whilst you would benefit from HSBC’s gains, you’d also be hit by declining business at the four other banks that had lost the price war.
The argument is that just as a reduction of airlines competing on a route reduces competition and boosts prices, so does an increase in common ownership.
Other researchers have suggested that the rise in common ownership may be responsible for other recent economic ills, especially the phenomenal rise in executive pay.
The anti-competition argument has been made most strongly in an academic paper called: ‘Anti-competitive effects of common ownership’ by Jose Azar, Martin C Schmalz and Isabel Tecu which was published in 2017.
The paper looks at the US airline industry to see whether cross-ownership of airlines by investors makes a difference. In particular, it looked at what happened when BlackRock bought the Barclays Global Investors business in 2009. The Barclays business included iShares ETFs.
Helpfully for the researchers, the impact of the merger differed across various airlines and routes. For example, prior to the merger, Barclays was the 5th largest shareholder in Airtran Airways where BlackRock was the 17th largest. The combined fund manager was the second largest shareholder in Airtran, so the merger made a significant difference. But with American Airlines, Barclays had a substantial stake in the airline but BlackRock did not, so the merger made little difference. So American didn’t have a newly powerful shareholder pushing for less competition.
Having done the grunt work, the researchers claim that if competing airlines on a route have a high incidence of common ownership, the fares will be 3 to 7% higher than under wholly separate ownership.
The same researchers have also studied the US banking industry and claim that greater common ownership led to higher fees and lower rates on savings accounts.
It didn’t take long for BlackRock to issue a counterblast to the research from Azar, Schmalz and Tecu.
BlackRock argues that it’s a mistake to view a fund management firm’s shareholding in a company as a single block of shares. The shares may be held in a range of different funds – some passive, some active – and different managers within the fund management firm may make varied decisions about their shares in this one company.
Other academic researchers have questioned the methodology used by Azar et al, and anyway, even if Azar et al are right about the negative impact of common ownership, we still shouldn’t forget the benefits that passive funds have brought for investors and perhaps for companies as well.
What’s more, activist investors push for rapid changes and are perhaps too short-termist, going for quick gains that aren’t in the long-term interests of a business. If passive investors are at the other end of the scale when it comes to engagement, you could at least argue that perhaps that’s not such a bad thing. And anyway, if index managers aren’t normally engaged with the management of their holdings, that suggest they won’t be pushing for more monopolistic behaviour.
Another argument is that if firms are using monopoly power to push up prices, that will push up costs for other businesses operating in other sectors. After all, many businesses are hit by higher costs if plane fares go up. BlackRock argues that even if a passive investor benefits from less competition in aviation, the investor will suffer as other firms in the passive fund are hit by higher aviation costs.
If we assume that Azar et al are right, then remedies are almost inevitable. In fact, we’ve already had some proposals from both economists and lawyers. One suggestion is that a passive fund would only be allowed to invest in one company in a sector. Another idea is that a fund manager’s stake in a company would be capped at 1%. Or maybe passive funds should lose their voting rights that go with their shares.
Trouble is, all these ideas would dramatically change passive investing. When you invest in a passive FTSE 100 fund, you want to invest in all the companies in the index, you want Glaxo AND AstraZeneca. Barclays AND HSBC. It seems unlikely that such drastic solutions would ever be implemented.
That said, this issue doesn’t look like going away. For now, there’s no conclusive evidence that ETFs are reducing competition across the economy. But that may change.