On this episode of the Capitalisn’t podcast, host Luigi Zingales shops for an airline ticket and ponders how our retirement investments might be hurting our wallets. New research suggests that giant mutual funds with large stakes in the companies of one industry can lead to reduced competition and higher prices.
Luigi: Hello. This is Luigi Zingales, a professor at the University of Chicago.
Kate: And I’m Kate Waldock, a professor at Georgetown, and you’re listening to Capitalisn’t. This is a podcast about how capitalism is working.
Luigi: Or, more importantly, how it isn’t, because capitalism without competition is like religion without God. It doesn’t work.
So yesterday I was on Expedia trying to book a flight actually to go see Kate in Washington, DC. And I discovered that it’s super expensive to travel from Chicago to Washington, DC. So let me make a comparison: a return ticket from Chicago to Washington, DC, is $325, but if I want to fly to Boston, it’s only $151. Why is that the case? It’s not that Boston is closer; in fact, Boston is farther away from Chicago than Washington, DC, is. So a possible reason is that half of the flights into Washington Reagan are actually controlled by America Airlines. By contrast, no airlines control more than 18 percent of the flights into Boston Logan.
The risk that market concentration might lead to higher prices for consumers is a central policy concern. In computing this concentration, however, the Department of Justice or the Federal Trade Commission always treat American Airlines as a separate company, for example, from Southwest, which is the second-largest airline in Washington, DC. Yet, the same mutual funds appear as the largest owners of both American Airlines and Southwest. Why should these owners push these two airlines to compete aggressively for the benefits of consumers but to the detriment of their investors?
And if they don’t, why shouldn’t we consider companies with the same owners as just one big company?
Kate: On today’s episode, we’re going to be talking about how the way you invest your retirement money might actually hurt your pocketbook.
Luigi: We economists call it common ownership when the institution we invest our money in ends up owning a lot of the competitors in the same industry, and that common ownership might actually lead to less competition and higher prices.
Kate: Basically when there’s common ownership across companies in an entire industry, then the incentives might be sort of similar to the incentives of a regular monopoly. So that across airlines, across American Airlines and Delta and JetBlue, if they’re all owned by the same people then they can act together as if they were one industry-wide monopoly. So that might lead to the same higher prices and lower quantities.
Luigi: And while monopoly’s as old as humankind, this phenomenon is a really recent and surprising phenomenon: the result of the widespread use of mutual funds and also, another sort of recent trend, which is indexation of mutual funds.
Kate: And so even though you might not realize it, by having money in a mutual fund or by working for a company that automatically puts money away for your retirement savings, that money is probably invested in some part in the stock market. And it’s invested through these companies, mutual funds or IRAs, companies that manage IRAs, that have just become huge. So over the course of the past 15 to 20 years, the way that most people held stocks was that they invested directly. But the way that it works now is that through your retirement account all this money is pooled across half of all Americans into these huge funds that now manage four-, five-, six-trillion-dollar portfolios. This gives them a whole lot of power.
Luigi: For example, Vanguard, who is one of the cheapest and the best of these, controls more than $4 trillion in assets, and so owns companies, owns a large stake in most companies in corporate America. And the same is true for BlackRock. So this trend has really created these enormous institutions with enormous amounts of ownership everywhere in corporate America and the world.
Kate: If you have $4 trillion of assets under management, you’re not just going to pick one or two companies to invest in. You are essentially diversifying across all companies.
Luigi: Now, while Kate is a wealthy investor, she doesn’t control ...
Kate: I’m not a wealthy investor.
Luigi: … all that amount of money, so the fact she is diversifying this way is not a problem per se. However the fact that Vanguard, Fidelity, BlackRock owns so many shares in competitors raises a concern. Why? Because they are paid to deliver performance to the investor. And the easiest way to deliver performance to the investor is to have companies collude to increase prices. Because if they do, they increase profits and share price goes up. So, Kate is very happy, as an investor, of this result, but is very unhappy as a consumer.
Kate: Exactly. And what we’re going to be talking about today is whether this is actually a problem. Should we be concerned about this common ownership issue that comes about through the fact that these mutual funds are really huge and they’re holding entire industries.
Luigi: There are two issues here. One, there is an issue about inequality in the sense that there are more consumers than there are producers or owners of producers. So, while most people have some form of retirement account, they consume more than they invest. And as a result, if you allow concentration and collusion to go on ... I use the word collusion here a little bit loosely, there would be a redistribution from the many to the few. And we know that this is one of the concerns that people raise about capitalism. And I think this is a legitimate concern these days, so I think that that would make the problem, if this is true, it would make the problem only worse.
Kate: So this notion of common ownership has existed in the theoretical economics literature for many decades. But it was only until recently that we’ve been able to start testing whether it has a real effect on prices for consumer goods. Some of the research that has been groundbreaking in this area was done by Martin Schmalz and José Azar, and Luigi why don’t you tell us a little bit about the research that they’ve done.
Luigi: They really document that where there is more common ownership, where the same people own all the airlines, you also have higher prices. Now as economists we tend to be skeptical about this correlation because we know that correlation is not causation. In real science you can address this problem with a real experiment. Economists, most of the time, cannot do real experiments and so they resort to something close that is called a natural experiment. And the authors of this study use a natural experiment to try to see whether there is a causal connection between the two.
So in this particular case, Barclays, a British bank, shortly after the financial crisis found itself in desperate need for cash. So they ended up selling their investment arm, and they ended up selling to BlackRock. So BlackRock all of a sudden saw its holding of airline stock increase dramatically. These researchers looked at what happened not in general to airline prices but precisely on those routes where this merger, or this acquisition, made common ownership go up. What they document is precisely where there is this increase in common ownership, prices go up by 10 percent and not everywhere else.
Kate: This type of research ... I do want to say off the bat that these authors are incredibly precise. They are incredibly careful about how they measure things. The run a bunch of tests to test alternative hypotheses, I mean they cover all of their bases. But at the end of the day they define a market as a route between two cities. And they construct a measure of common ownership at the carrier level at each route. And then they say that this acquisition of Barclays Global Investors was a random shock that had nothing to do with anything else that might change prices at that route level.
To be honest, what I find confusing about this is that I don’t know what affects changes at the route level. I don’t know if airlines use some sort of pricing algorithm, I don’t know if there’s some person who’s actually changing prices at the computer as he sees supply and demand fluctuate. It’s just hard for me to get an intuitive sense of what’s causing prices to change. And so it’s hard for me to say whether this acquisition that happened during the financial crisis—when tons of other things were going on, when companies were going bankrupt, when supply and demand was changing—it’s hard for me to say whether that was truly uncorrelated with anything else that could be affecting prices.
Luigi: You are right, but let’s remind our listener that this is only one of the many things they do. In a sense they do find in general a correlation between higher prices and more common ownership. And this experiment, this natural experiment they use, is only one of many, many things that they do. Now, I understand that it’s hard to appreciate how this mechanism really works. However, as empirical economists, we see that there is certainly a motive to increase prices if you have common ownership, and you do see some evidence. So I do think it’s a phenomenon we should be very concerned about.
Kate: Yes they do run a ton of tests, and yes they are incredibly thorough. I mean much more thorough than you would see on a typical paper working with data in our field. But one of the other things that they acknowledge affects pricing in the airline industry is concentration in the industry itself. A little over 10 years ago, the top airlines held like 60 percent of the market share. And now it’s something like 85 percent. And that didn’t show up in the routes at all. I mean, there’s been a ton of mergers, there’s been a ton of bankruptcies, and none of this was reflected in the industry concentration measures. So it’s hard for me to imagine that maybe there was something else going on in industry concentration that they just weren’t picking up.
Luigi: Yeah, but remember, they don’t find this just in airlines. They have another paper looking at the banking industry. And they find that when there is more common ownership in the banking industry, actually banks pay less for your deposit. So I think it seems that it’s not just a problem of airlines, it’s a general problem.
Kate: OK, so let’s go to banks now. What they’re claiming is that at the county level, banks in counties in which there’s more common ownership charge higher fees and they give you less return for your CD investments. Say, your one- or two-year CDs. What is the actual mechanism here? I mean, is there some person at a regional bank in like Greenwood, Kansas, who is trying to figure out how much they should be charging for overdrafts and the way that he does this is to look at the ownership of all the other banks in town, the ownership of his bank, whether there’s common ownership, whether Vanguard owns 5 percent of his bank and 10 percent of CitiBank next door, and he’s like, “Oh, well there’s common ownership and therefore we should be acting cooperatively with the other banks and so we should be charging higher overdraft fees.” It’s hard for me to imagine that that could possibly be happening.
Luigi: I agree with you, I don’t think that the mechanism you describe is realistic. However, as economists we believe in incentives. And there are a lot of incentives that can go in that direction. Let me give you an example: in 2015 there was an activist investor that was trying to take over DuPont. DuPont is a big chemical company but also produces a lot of agricultural products and seeds. This investor really wanted DuPont to be more aggressive and gain market share over Monsanto. This investor was defeated in a proxy fight. Who voted against in this proxy fight? Vanguard. Fidelity. All those large institutional investors who own shares both in Monsanto and in DuPont. And as a result, actually DuPont ended up merging later without creating, again, more concentration rather than competing aggressively with Monsanto.
So the story is you don’t need to tell the little guy in the county to increase its fees. It is the incentives at the corporate headquarters that trickles down into a different behavior.
Kate: Yeah, but it’s a well-known fact that mutual funds typically side with management in these proxy battles. They’ve historically been very passive investors. They’re not like the David Einhorn who is out there sounding the bell and who is trying to get management replaced or who is trying to get huge changes in corporate strategy enacted. These big mutual funds like Vanguard and like BlackRock, whenever they vote for changes at the corporate level they’re usually pretty chill. They don’t want to rock the boat. They don’t want to disturb the CEOs because they generally trust that CEOs do a good job at what they do. And so it’s not like in that case they voted against the activist because they necessarily wanted more industry concentration or more cooperation amongst the industry. It’s just that they were doing what they always do.
Luigi: You’re only partially right here. It’s true institutional investors tend to vote with management but it’s also true that they tend to follow the indication of some proxy advisors. In particular, Institutional Shareholder Services, ISS. And in this case ISS actually recommended to vote in favor of the activist investor. And they did not follow this advice and voted in a different way. So it was not as passive a behavior as you describe. But even if we buy your interpretation that these guys are passive, this might lead to the same behavior. For instance, if I know as a manager that I am owned by the same guys, by Fidelity and Vanguard, etc., as my competitors. I know that nobody can take me over because they’re going to side with me. And so I don’t need to actually be very active in maximizing profits of this company. I can take a basically easy life approach. This leads to what we call in economics tacit collusion. Tacit, because it’s not a guy conspiring in a seat in a smokey room with my competitor and fix the price. But for all practical purposes the result is the same.
Kate: I think that’s an interesting point. Another way of putting this is that this is the crowding out theory of common ownership. That the way that big mutual funds that own a bunch of shares of all firms in an industry, the way that they actually get the industry to end up pricing in a monopolistic way isn’t that they’re encouraging collusion in pricing across the firms in that industry. It’s just that they’re not doing anything. They’re just sitting by and they’re letting the managers do whatever they want, and because they’re not actually trying to force the firm to compete aggressively, then managers end up just looking somewhat lazy. And I think that this has some validity. It makes a lot of sense in terms of a mechanism to me.
But if that is the case, if that’s the way in which common ownership leads to changes in pricing, then I want to see a paper on that. And I want to see how those mutual funds are actually voting against activist investors, such as hedge funds, or they’re not, and see if there’s a relationship between the extent to which they vote against activists and how much they hold shares across all firms.
Luigi: It seems you have a new paper to write, Kate.
Kate: I’m not in this field, I study bankruptcy. This is not my thing.
Luigi: Actually, that’s a pretty good field. Because many airlines go bankrupt, so you might have a synergy here between the two.
Just to give you an example of how this is pervasive, let’s look at drugstore pharmacists. Not only is there a huge concentration but basically three chains, CVS, Walgreens, and Rite-Aid, that control most of the local markets. And what you have to realize in most large corporations in the United States, you don’t need to own 51 percent of the stock to control a stock. So when we look at CVS there is nobody that owns more than Vanguard. Vanguard is the largest owner with 6.7 percent. And the second largest is BlackRock. You go to Rite Aid, it’s exactly the same. Vanguard is the largest owner with 7.2, and BlackRock is next with 4.2.
Kate: Yeah, so what that might end up translating into is this crowding out effect. That if you’re an activist investor and you’re looking around at all the pharmacies and you’re seeing that CVS and Walgreens and Rite Aid, the major investors to the extent of 13-14 percent are the mutual funds, then that’s going to deter you from purchasing shares in those companies because it’s just too large of an investment to try and purchase more than 14 percent. So even though 14 percent on an absolute level might seem small in terms of controlling the company, what’s important is that it’s large enough for activist investors not to want to come in and purchase more.
Luigi: But Kate, we started this episode by basically telling people that the way they invest really ends up damaging their pocketbook, damaging the way they consume. What is our recipe for those investors?
Kate: That is a tough question. I mean, if the problem is then that they are causing their portfolio holdings, the firms that they hold, to act like monopolies, then that’s going to lead directly to higher prices at, let’s say, the pharmacy. It’s going to lead to higher prices in the water that I buy at CVS. And it’s going to lead to higher prices in the airline ticket that I buy to fly to Chicago. But essentially it all evens out, right? You get a higher return on your retirement savings. You have to pay higher prices at the drugstore and for your airline tickets.
Luigi: But Kate, I don’t want to be too philosophical, but it is true that as economists we think that monopolies are bad no matter what. Even if you redistribute money to the right consumers, I think that there is some deadweight loss, as we call it in economics. There are purchases that people would have made and they don’t as a result of higher prices. And this is not a transfer, this is a net loss. So I think it’s not as benign as you would like to portray.
Kate: I know. I’m being a little unfair to the economics profession just because I personally think that inequality is a huge problem right now.
Luigi: What I want to make sure that comes across very clearly is we’re not telling investors not to diversify their portfolio, not to buy index funds. I still think that the right thing to do for an investor, and that’s what I do myself, is to diversify your portfolio and buy index funds. Maybe what we should tell people to do is to be more active in asking those funds to be more accountable. Ask them what they do to avoid this problem. Are they really paying attention, or not? And I think that that’s what would be helpful if we all do a bit more. And I think what makes it problematic from my point of view is that there’s not an easy solution. Because if we take away the ability, for example of mutual funds, to have a voice in corporate governance, we’re actually probably making the problem worse rather than better because we’re going to have a lot of managers that are completely self-interested. That are not motivated and don’t try to maximize profits at all. So I think that it might be that the solution is worse than the problem.
Kate: Part of me wonders whether this wouldn’t just naturally lead to a market solution. Which is that ultimately, let’s say over time these mutual funds end up holding entire swaths of all firms within industries that are publicly traded. And then the firms stop competing against one another. Within the industry they start charging higher prices, the managers get lazy. These companies end up not being run very well. Then this is just an opportunity for private equity firms to come in and to take over some of those lazy companies. So, to take the companies private and to have that particular company start competing more aggressively against the other, lazier, publicly traded companies. And so in this market what will happen is that eventually companies will be taken private. Those companies will outperform. And then the managers of the public companies will have to wake up and they’ll have to start taking more action. And so I think that there is sort of a market solution to this. We don’t necessarily need to step in with regulation.
Luigi: Wow Kate! You sound like more Chicago-style than I am!
Luigi: I think you’re right, in the long run maybe everything would be solved. In the long run. As Keynes said, in the long run we’re all dead. So we need to be careful of being so cavalier that it would be fixed. But you’re right that there might be a market solution to this problem. My concern is that if I am a private equity firm and I’m in a market in which everybody else colludes, my first reaction is to collude as well. And it’s going to be very hard for me to be the only guy fighting against everybody else.
Kate: Yeah, and I’m going to undermine my own argument because I don’t want to seem overly pro-market. But a problem with this is that eventually that could lead to more privatization, fewer firms being publicly traded. And the people who invest in private equity, the types of people who have their money in private equity firms, are very different from the types of people who have their money in 401(k)s. And so it’s a different set of people who would be benefiting from competition and I think that the returns might ultimately go to richer people, and that might aggravate the inequality problem. So we don’t want that outcome to ultimately happen, which means that we might need some more regulation to prevent that state of the world from coming about. Which as Luigi said, it’s hard to devise regulation that would prevent this issue of common ownership leading to monopolistic-type behavior without at the same time leading firms to act in a way that’s not beneficial to shareholders.
So, one of the regulations that does exist is that there was some antitrust regulation from the 1970s. There’s this thing called the Hart-Scott-Rodino Act, and as part of that firms have to file information with antitrust authorities if they buy a bunch of stock. It used to be $50 million in stock, now it’s like $65 million. But if you claim that you’re a passive institutional investor, you’re only buying that stock for investment purposes, not for actually controlling the corporation, then you get a waiver and you don’t have to file with the antitrust authorities. What I think is kind of ironic is that the antitrust authorities have been super lax when it comes to institutional investors like Vanguard and BlackRock, whereas there was this one strange instance where a hedge fund came around and they bought a really tiny fraction of Yahoo, and they didn’t file with the regulators, and then they got in trouble.
Luigi: Yeah, but as you know, very often regulation is used to protect against newcomers to the industry rather than to actually pursue the benefit of regulation. But I’m a big fan of Justice Brandeis’ position that sunlight is the best disinfectant and the streetlight the best policeman. So I think that you’re absolutely right that enforcing the Scott-Rodino Act is good. I’m not ready to jump the gun on some sort of intervention, but it’s something that we need to watch out for and we need to know more. And I think this is what good economic research is about. To point out problems that we did not even know existed.
Kate: Yeah, Luigi, on this podcast I think you’ve gotten me to say twice that hedge funds are the good guys, and once to say that the market just regulates itself. So, somehow you’ve managed to convince me to turn all of my beliefs on their head!