Are index funds illegal?

The theory is simple. A handful of big asset managers run giant index funds and own large chunks of every public company. Roughly speaking, the “Big Three” managers (BlackRock Inc., Vanguard Group and State Street Corp.) together own 20% or so of most public companies, and when you add in smaller quasi-indexers it is approximately true that most companies are mostly owned by diversified institutional investors. Therefore, the theory goes, most companies will tend to act in the interests of those diversified investors.

Often that means that the companies will do what they would do anyway, if they had different, non-diversified shareholders: They will try to increase sales and profits, etc. But not always. In particular, it does the shareholders no good if one company increases its market share at the expense of another company: The shareholders own both companies, so what they gain on one they lose on the other. In fact, if one company increases its market share by cutting prices and starting a price war, then the shareholders lose more than they gain. The shareholders own every company, and they want what is best for the companies collectively, not what is best for any individual company.

If you take this theory seriously, you might worry about the antitrust implications. If all the companies in an industry are owned by the same handful of owners, doesn’t that structure resemble the “trusts” that the antitrust laws were meant to stop? If the owners can pressure all the companies to act in their collective interest, won’t they push the companies to reduce competition and raise prices? Isn’t it bad for consumers if all the companies have the same owners? Some finance and legal academics think the answer is yes, and we have been talking about this idea for almost a decade.

This theory is controversial, in part because Big Three index fund managers do not generally go around saying things like “we want our companies to reduce production to have higher profit margins.” They don’t say this in part because that would be an antitrust problem, but also because they tend not to think that way. If you run an index fund, it is a bit silly to spend a lot of time analyzing the businesses of the companies you own and pushing them to make operational improvements. You are targeting the index return; whatever the companies do is fine, for you, since your job is to reflect their performance, not improve it. In theory you might be better off if the index return was higher — more people might buy your funds if stocks always went up — but that seems pretty indirect, and in practice the main way you compete, as an index fund manager, is by charging lower fees. It should be very cheap to run an index fund — all you have to do is buy a list of stocks and hold them — so it mostly is. You can’t afford to spend a lot of money hiring analysts to tell companies how to improve their performance.

There is, however, an important exception. The exception sometimes goes by the name “systemic stewardship,” though it is sometimes loosely called “ESG” (for environmental, social and governance investing). The idea is that if you can identify systemic factors that affect all of the stocks in your portfolio, then you should push companies to improve their performance in those areas. And by “systemic factors” I mean mostly climate change, though also some other stuff. But the central intuition does seem to be “climate change will cause trouble for all of our companies, so we want all of our companies to emit less carbon, because that will be good for all of them.” This is worth doing for index fund managers because:

1.   It’s relatively cheap. You need fewer people to say “global warming will be a big problem for a lot of companies” than you would to analyze every company’s operations and suggest specific improvements.

2.   It’s quite scalable. If you own 500 companies, finding a way to improve one company’s performance won’t do that much for your fund’s returns, but finding a way to improve all 500 companies’ performance will. Again, you are mostly measured against the index return, so improving that return doesn’t help you that much, but it helps a little. (Also you are a fiduciary for your clients, so you should try to improve the index’s return, if it’s relatively easy.)

3.   It is — or was — good marketing. Low fees are not the only way to compete as an index fund manager. Being thoughtful about systemic issues is a way to look like a responsible steward of your clients’ capital, a way to talk to clients about your investment process that isn’t “well there’s this list of stocks and we buy them all.” And in particular, looking thoughtful about climate issues is, or was, a way to attract money from clients who are also worried about climate change and want an asset manager who cares about the issue and pushes companies to pollute less.

This has changed in recent years, as US Republican politicians have led a backlash against ESG, and it is now sort of bad marketing for US investment managers to care too visibly about climate change. But for a while it was a thing.

And so the rough message from the big asset managers was “we do not actually push our portfolio companies to reduce production to keep prices high, because that would be crazy, but we do push our portfolio companies to pollute less, because that is good systemic stewardship.”

But there is a tension here. You might ask: “Well, what about the coal companies? You own a lot of their stocks. You push them to pollute less. Pushing coal companies to pollute less means pushing them to mine less coal. That probably will have the effect of pushing up the price of coal, which is what you want, as a good environmental steward. (It will make it more expensive to burn coal, so less coal will be burned, so carbon emissions will be lower.) But it will also mean higher profit margins and lower production from the coal companies. Which is exactly the classic antitrust worry about index funds.”

I think the traditional answer to that line of questioning — and to a lot of this stuff about index funds and antitrust — was “oh come on, that’s stupid, that’s not the right way to think about anything.” But these questions are becoming more mainstream, and I am not sure that “oh come on” will continue to work as an answer. Last week Bloomberg’s Saijel Kishan reported:

That’s not what they’re suggesting! They’re not suggesting that BlackRock wanted to harm the coal companies! They’re suggesting that BlackRock wanted the coal companies to cut production and increase margins.Classic antitrust stuff, with just a hint of ESG. The complaint begins:

The argument here is that the Big Three’s systemic stewardship of coal companies was good for the coal companies, that the Big Three pushed coal companies to cut production, raise prices and thus increase their profits:

There is nothing “ESG” in the paragraphs I have quoted, and you could imagine telling the same sort of story about, for instance, airline seats. When we first started talking about index funds and antitrust, it was because of a paper on the “Anticompetitive Effects of Common Ownership” in the airline industry, arguing that increased common ownership of airlines leads to less competition and higher ticket prices. But if you are telling this story about airline tickets, it is hard to find cases of BlackRock going around saying things like “we want our airlines to offer fewer seats and raise prices.” It’s maybe a little easier with coal:

That’s not the same as saying “we asked them to mine less coal,” but there is not a comparable report saying that Vanguard goes around asking airlines for clear disclosures of how airline tickets remain relevant for their customer base over 10, 20 and 30 years. The big common owners do put some sort of pressure on coal companies that they don’t put on other companies, and it arguably has some effect:

Obviously there are other explanations. One explanation would be that ESG is correct. Perhaps Vanguard is correct to worry about “how thermal coal remains relevant for a company’s customer base and the market it serves over 10, 20, and 30, years,” and the companies themselves also worry about it. Perhaps the coal companies think “eventually the world will want cleaner energy and less thermal coal, so it is in our long-term interests to invest less in developing coal mines because they are not a good proposition for the long run.” If the long-term outlook for coal is bad, there will be less long-term investment in coal mining, which might lead to higher prices now. Perhaps the coal companies and their investors independently make sensible decisions about their own long-term businesses, and there’s no need for them to coordinate to reduce supply and drive up prices.

But it is a weird and somewhat new feature of modern markets that all the companies are owned by the same shareholders. And increasingly that causes trouble for those shareholders.