(Article from Registered Funds Alert, May 2017)
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In our November 2015 Alert, we highlighted two academic papers that raised antitrust concerns related to investments by mutual funds and asset managers in competitors within concentrated industries, such as the airline or banking industries. Currently, passive investors enjoy an exemption from the Clayton Act, which is one of the federal antitrust statutes, on the theory that a purchase of a security by a person for investment purposes – rather than for purposes of exercising control – does not give rise to anticompetitive concerns with respect to the portfolio company’s industry. The academic papers laid the groundwork for questioning the availability of the passive investor defense for institutional investors, such as mutual funds and asset managers, based on the theory that they may not be truly “passive,” and “horizontal ownership” could reduce the incentives for portfolio companies to compete (which could explain, for instance, the increase in fares in the airline industry).
Since we initially addressed the topic, additional academic papers have been published, both supporting and disputing the anticompetitive effect of such investments, and some policymakers have taken an interest in the issue. For example, Bill Baer, former Assistant Attorney General for the Antitrust Division of the Department of Justice, testified before a Senate subcommittee in March 2016 that the Department was “looking at” the issue of horizontal ownership in more than one industry. Additionally, SEC Commissioner Kara Stein specifically mentioned asset managers’ ownership of competing companies as raising potential transparency and disclosure issues in her speech at the annual SEC Speaks conference, and Senator Amy Klobuchar (D-MN), ranking member on the Senate Antitrust Subcommittee, noted in a March 2017 speech that it is “easy to see” how such cross-ownership could hurt consumers.
This issue seems to have garnered attention from policymakers after the New York Times published an opinion piece in December 2016 by the authors of an academic paper that proposes restricting the ability of institutional investors to own stakes in competing companies in concentrated industries. Some have cautioned policymakers from relying on the early academic papers until further research is done. For example, BlackRock published a ViewPoint in March 2017, noting that the academic research ignored practical considerations and the realities of the asset management business. Additionally, an economic paper by Daniel P. O’Brien and Keith Waehrer published in February 2017 found several flaws in the early academic studies and argued that it is premature for policy to be made when much work needs to be done to demonstrate whether there may be a causal relationship between horizontal shareholding and decreased competition.[1] In this Alert, we address the policy proposal set forth in that New York Times opinion piece, and the underlying academic paper, which suggest imposing a limit on the ability of mutual funds and asset managers to invest in concentrated industries. Our view is that the proposal would create significant market risks that could outweigh any benefit.
Rise of Institutional Investors
The New York Times opinion piece and academic paper by the same authors note that institutional investors, including asset managers and mutual funds, own approximately 70% of U.S. publicly traded stocks, whereas in 1950 that figure was 7%. The authors also state that the rise of the institutional investor has “undercut middle-class living standards.” What the authors fail to note, however, is that a large part of this growth is due to the fact that mutual funds are now owned by average investors. According to the ICI’s Fact Book, over 44% of U.S. households own investment companies (up from 4.6% in 1980), and retail investors own 89% of fund assets. Among households that own mutual funds, 51% have household incomes of less than $100,000 and 89% have household incomes of less than $200,000.[2] Since 1980, the percentage of household assets held in mutual funds has increased from 3% to 22%. As the industry has grown, fees and expenses have shrunk, falling by 36% in this century. In other words, average retail investors have drastically increased their reliance on mutual funds to access investment opportunities, and those investment opportunities are available to such investors in increasingly cost-effective ways.
The Policy Proposal
Academics Eric A. Posner, Fiona Scott Morton and E. Glen Weyl authored an academic paper in November 2016, and the opinion piece referenced above, in which they essentially propose that mutual funds and asset managers be limited to either (i) investing in only a single issuer within a concentrated industry or (ii) owning less than 1% of the total size of a concentrated industry. Based on recent academic papers, examples of potential “concentrated industries” include the airline and banking industries. The proposal would apply the 1% industry cap to an asset manager’s clients in the aggregate, meaning that all of the registered funds in a fund complex would have to share that 1% exposure with any private clients (but there would be no cap if all clients were invested in a single issuer from that industry).
Impact on Diversification and Index Funds
The authors acknowledge that their proposal could be interpreted as conflicting with modern portfolio theory and the widely accepted principle that diversification, which reduces exposure to individual issuers, is a key component of smart investing and risk management. However, the authors downplay the cost of the reduced diversification as “minimal.” BlackRock, in its ViewPoint piece, took issue with this characterization of the costs of reducing diversification. For example, BlackRock points to a comparison of the annualized return and volatility of various sectors against the single issuer with the largest market capitalization in each sector as an illustration of how investing in a single issuer generally presents greater volatility risk and does not always mirror the sector’s investment performance.
In their opinion piece, the authors of the proposed restrictions unwittingly provided the perfect example of why diversification is important:
“Large institutional investors could still provide cheap, diversified mutual funds to consumers under our proposal because the benefits of diversification within an industry are tiny compared with diversification across industries. A fund owning United Airlines can diversify with holdings in Walgreens; it does not need to own Delta as well.”
As recent incidents involving United Airlines have shown, concentration in a particular issuer can be extremely risky and subject investors to increased volatility. United Airlines’ stock price reportedly fell as much as 6.3% in a single day after a passenger was forcibly removed from a flight and disturbing footage of the incident spread virally across the internet and media outlets. Similarly, a large national bank recently saw its stock price decline to an even greater degree in the wake of a regulatory enforcement matter and accompanying negative media coverage. If an investor needed to redeem their investment in an index fund, particularly one that focuses on the financial sector, shortly after those incidents, the value of their investment would have been significantly lower if the fund were concentrated in the bank or airline in question rather than one that was truly diversified. Further, as noted above, funds concentrated in a single bank or airline may not have been able to exit their positions, and if they were able to, might have theoretically created extraordinary downward pressure on the issuer’s stock price.
The authors also appear to acknowledge that their proposal would disproportionately affect funds that seek to track an index of securities. Index funds are widely regarded as a low-cost way for retail investors to diversify their portfolios and gain exposure to broad market sectors. Many of the market’s largest index funds are run by the largest asset managers, several of which manage in excess of a trillion dollars of client assets. If these large index fund managers had to comply with the proposed restrictions, absurd results would occur. Index funds that track the S&P 500 Index currently invest more than 5% of their assets in banks to track the weighting of the index. If all bank holdings for these managers’ clients needed to be concentrated in a single issuer, the largest S&P 500 index fund currently offered would need to invest upwards of $10-12 billion in a single bank. Further, if the manager’s other clients wanted exposure to the banking industry, that concentrated exposure would be much higher, and may even result in the manager’s clients holding a significant, and possibly even a controlling, position in the issuer. For example, if a hypothetical manager’s clients, in the aggregate, were to own 5% of each of the ten largest airlines, consolidating those positions into a single issuer could result in the manager’s clients owning 30, 40 or even 50% (or more) of one airline. Not only would that mean that the asset manager could no longer be treated as a “passive investor” for antitrust purposes, but in that scenario the asset manager’s fiduciary duties to its clients might require it to take an active role in the airline’s management. Additionally, a fund so concentrated in an issuer could face significant obstacles to divesting its position to meet redemption requests or to shift assets to another issuer in the same industry, including Securities Act of 1933 restrictions on the ability of large shareholders to dispose of their positions.
This example raises another issue that would arise under the proposals. A large part of the reason index funds are low-cost investment options is that investment decisions are largely pre-determined, as the fund tracks its index and does not require significant active management with respect to its investment portfolio. In a world where an index fund might be limited to a single issuer in a given industry in order to track the exposure of its index, managers would presumably, in the exercise of their fiduciary duties, need to conduct research and diligence to invest in the issuer that they believe is the best investment for the fund. This likely would result in increased costs for index funds.
While it remains to be seen whether further study finds any measure of causality between horizontal shareholding and competition in concentrated industries, the policy proposals put forth thus far are not the answer, as they could have disastrous effects on equity markets and reduce access to investment opportunities for average retail investors.
[1] The authors of this economic paper acknowledge that the ICI partially funded their research, without substantive input.
[2] While there is no formal definition of “middle-class,” the Pew Research Center has used the range of two-thirds to double the national median income, adjusted for household size. For example, based on 2014 data, a four-person household would be deemed “middle-class” if its income ranged from approximately $48,000 to $144,000.