Index Funds May Work a Little Too Well

http://www.bloombergview.com/articles/2015-07-22/index-funds-may-work-a-little-too-well

by chollida1 • 11 years ago

307 198 11 years ago

howeyc• 11 years ago

Interesting. The idea is that index funds implicitly favor collusion between companies in the same industry since investors/institutions own the competing companies (perhaps even at the same weight). That is, an index owning both Coke and Pepsi may not be too keen on one slaying the other, but instead for them both to become bigger together, yet separate.

There's also the idea that index investing "should" be considered illegal because of the possible antitrust issues.

Also, the rise of index investing puts more favor to stock buybacks/dividends as opposed to reinvestment. The idea being (as an example) that the index would rather take Coke's profits and redirect to a smaller higher-growth-potential company (or even spread it out more evenly among all holdings). However, if no index investing, perhaps investors would be more willing to "ride it out" with Coke reinvesting a lot more profits back into the business (maybe the don't own Pepsi, or other soft-drink companies and want to see them all get demolished).

paganel3• 11 years ago

In other words, there's no "silver bullet", no matter the industry. I also think that we should stop believing in the "wonder" of compound interest and act accordingly, because it will come a time when this "wonder" will prove to be just that: a thing that cannot last forever. The same goes for a guaranteed rate of return on investment.

maaku• 11 years ago

where did you pull that from?

ryangittins• 11 years ago

What are you talking about? No one believes in the "wonder" of compound interest. They believe in the mathematics.

nemo44x• 11 years ago

Compound interest accumulation, over a long enough period of time has historically ended in blood & ashes and redistribution.

brc4• 11 years ago

Seriously. Sometimes I wonder about who actually is visiting this site.

The 'wonder' of compounding interest?

It's merely the monetary representation of the return on investment in productive activities and assets. The reason money has a cost is because it can be converted into useful, productive activities, so the holder needs to be compensated for that.

The 'wonder' is how animal herds and horticulural products increase enough in quantity to feed us all.

Building a shelter over your head is compounding interest at work. You sleep better, stay healthier and have more time to do other things. Same goes for a knife or a spear, or a factory or a computer.

I find it incredibly odd that we have people running around saying 'we have to stop growth' 'growth is bad'. Yet, on all measurable criteria - every single one of them - things keep getting better. This is because of the compouding effect of investment in knowledge and productive capacity.

I'm not sure where the growth-hate comes from, if it is ignorance or just some sort of strange moral fashion to hate on the modern world. Either way, a class of people have convinced themselves that - of the entire trajectory of growth from nomadic paleoithic peoples to now - it's right at this point the wheels are about to fall off. Strikes me as a little narcissistic, really.

aetherson• 11 years ago

An index owning both Coke and Pepsi wants the soft-drink market to grow bigger -- it is presumably indifferent to whether Coke slays Pepsi, Pepsi slays Coke, or both grow bigger together, as long as the total market increases.

Which is arguably a good thing. Let's say that Coke has 60% of the market and Pepsi has 40% of the market. If Coke's investors are separate from Pepsi's investors, then it would be in their interests to take a tactic that kills Pepsi and allocates half of its market share to Coke and the other half goes up in smoke to a smaller overall market -- now Coke is half again as big as it was! But the industry is smaller.

That said, I'm not sure that realistically, market-decreasing tactics really exist in most cases -- I can't think of a real world example.

The collusion argument is certainly interesting.

makomk• 11 years ago

More precisely, an index fund owning both Coke and Pepsi wants profits from the soft-drink market to grow bigger, and the easiest way for that to happen is for both companies to increase their prices at the same time. Note that this is exactly the opposite of how competition in capitalism is meant to work - it's meant to drive down prices towards the cost of production, increasing overall efficiency as it does. Note also that this likely also results in selling less soft drinks than if the companies were actually competing, because increasing prices generally decreases sales.

blueside• 11 years ago

Why can't the index fund just sell Pepsi and keep Coke? Just because one of the companies does bad means you have to divest from the entire industry?

return0• 11 years ago

It wants its profits to grow bigger though, regardless of consumer benefit, which is a lot like creating a cartel.

ci5er• 11 years ago

That said, I'm not sure that realistically, market-decreasing tactics really exist in most cases -- I can't think of a real world example.

What do you mean? Of the Coke/Pepsi type market? Giants whacking away at each other?

If you are looking more broadly - the 'market decreasing tactics' is one aspect of what the innovator's dilemma is about. One of my favorite VC types, likes to invest in companies that fill the following thesis: "AcmeCo is a new entrant, with some cool tools, into an aging $50B (or whatever) / year industry. When AcmeCo is done lighting a neutron bomb in the industry and the dust settles, it is now a $5B industry, and AcmeCo is the last man standing with 60%+ market share."

The collusion argument is certainly interesting.

That it is. I had not come across some of the structure of the argumentation in this article before.

rhino369• 11 years ago

Maybe the solution should be that index funds just shouldn't be able to vote their shares.

praptak5• 11 years ago

Interesting. With enough optimisation of the mechanisms of modern capitalism we arrive at a state where a single amorphous entity owns the economy so there are no incentives created by competition.

uptown• 11 years ago

You could say the same for politics.

danharaj• 11 years ago

That is true if you limit yourself to preserving some political structure. It is not true if you consider revolutions and radical changes to be politically legitimate. There is no ideology or system you can encode in prescriptive rules that endures forever. Capitalism(s) has had a long run, but so did feudalism(s). I pluralize because those systems have changed. What happened to feudalism in the end was that its fundamental tenets were overthrown. What remained could not be called feudalism. It remains to be seen if and how that occurs with capitalism. What can be discarded to make the incumbent institutions endure? How long will that last?

praptak5• 11 years ago

I don't think any political entity owns the economy. Quite the opposite - campaign funding is how the economy controls politics.

TeMPOraL2• 11 years ago

Isn't the whole capitalism based on promising people monopoly but not letting them actually get it? I.e. no profit-seeking entrepreneur in their right mind would act to create competition for themselves. Competition means waste of time and resources, so there's no surprise every player tries to figure a way how to reduce it, aiming for bigger and bigger pieces of the whole pie in the process. The state you described seems like a part of the natural evolution of market incentives.

pcmaffey• 11 years ago

Except markets are not a zero-sum game. The best capitalists make the pie bigger by creating new value.

praptak5• 11 years ago

"But not letting them actually get it."

Article thesis is that funds go around that limit. Not even on purpose, just by their definition. No single company has monopoly but index funds collectively own all of them.

baseballmerpeak• 11 years ago

"Competition is for losers." - Peter Thiel

dataker2• 11 years ago

There's a difference between natural monopolies and government-backed/tied monopolies.

dragonwriter• 11 years ago

Isn't the whole capitalism based on promising people monopoly but not letting them actually get it?

No. Modern mixed economies, which have replaced capitalism as the dominant system of the developed world since capitalism was described in the 19th Century, are based on incorporating the features of capitalism that tend toward monopoly, but incorporating other features to impair the development of some monopolies and restrict the adverse impacts of other monopolies.

Capitalism itself does nothing to control monopolies.

Brushfire• 11 years ago

The beauty of modern capitalism is that it is more about incentives, not performance.

Incentives drive swings between consolidation and fragmentation, because individuals believe they can profit from being different from the status quo.

dade_• 11 years ago

I don't see any risk of this scenario. I invest heavily in index funds. Generally my focus is on which countries / regions I believe will outperform others. It has provided strong returns without active trading.

xux• 11 years ago

I think you've just described Berkshire Hathway

VLM2• 11 years ago

The OSS model is instructive as an analogy.

80% and shrinking of the fund market is closed and proprietary software. Its very expensive and relies on single points of failure, often one person per fund. There's a lot of propagandizing that they're the only way to invest or best or whatever.

20% and growing of the fund market is free open source allocation, here is TODAYs definition of an index now buy stock to reflect it. Needless to say its incredibly cheap compared to the closed source funds and arguably gives an overall higher rate of return.

Some of the lower rate of return of closed source funds is because of their massive advertising and propaganda budget spent to convince investors that they're a better deal. Sometimes, by obscure enough definitions of better deal, they are. Usually not. Needless to say someone who's paycheck depends on FUDing the free competition isn't going to have anything nice to say about FOSS or index funds.

The idea that FOSS or an index fund is a conspiracy is kind of weird. If index funds are made illegal on that ground, I suppose Emacs will be made illegal soon because its unfair to make individual proprietary editor writers compete with the entire world teamed up against them. "The right of the rich to privatize gains and socialize losses shall not be infringed" and possibly other constitutional amendments will be marched out in the corporate press, etc.

stdbrouw2• 11 years ago

The article is not about index funds competing with alternate investment opportunities and whether or not the competition is fair, it's about what index funds do to the competitiveness of the companies they invest in.

VLM2• 11 years ago

Exactly, that's the best way to present FUD.

Don't tell people you're trying to grind an axe, just say I'm merely providing free advice from my grindstone financed workplace.

curiousjorge• 11 years ago

Index fund works well because it's diluted. When you invest in a single company there are many unknowns and downsides but stretched across the sector, you find less risk (how likely is it that other than Toshiba and Kodak are cooking books).

However, the returns are also limited to the sector as well.

I admit picking undervalued companies AND being solvent enough before the market reacts rationally is a huge undertaking and why there's so little of successful value investors.

obblekk2• 11 years ago

This is cool, but incomplete. An index fund would still want competition if by competing, Pepsi gains 100% and Coke loses 1%. i.e., in any case where competition grows the pie rather than cuts it up differently, the index fund would want competition.

I claim this is the right result. We should discourage competition where everyone ends off worse, and encourage competition otherwise. Individuals competing do things like dump goods below cost to bankrupt smaller competitors; an index would perhaps not do that.

praptak5• 11 years ago

"Everyone ends off worse" - by a strange definition of everyone that leaves consumers out of the equation.

obblekk2• 11 years ago

Well, consumers shouldn't be much worse off, otherwise it creates an arbitrage opportunity.

Although Pepsi and Coke may be indexed, they aren't the same entity allowing investors to just own one. If there's some action that Pepsi could take that would massively reallocate the pie in it's favor (by winning over consumer for instance), then investors ought to start massing to it and becoming more activist. This would come at the expense of the index of course.

So really as long as there's easy 'severability' of the companies in the index, they shouldn't be overtly monopolistic.

But I agree in industries with high capital requirements (energy, biotech, etc.) it may be impossible to separate out the companies and then they would be de facto merged.

This really is an interesting idea because a solution seems hard to find. Outright banning indexing would be nearly impossible to enforce (large pension funds could reproduce the index at a slighter higher cost).

davidw• 11 years ago

Consumers would be better off avoiding both Coke and Pepsi, most likely, aside from a very occasional one.

http://www.ncbi.nlm.nih.gov/pubmed/23488503

mcguire3• 11 years ago

I agree with you, but the article is making a pretty strong argument that indexing discourages competition in a way that makes everyone worse off.

"[Elhauge:] 'Fourth, if index funds alone would create a problem of anticompetitive horizontal shareholding in a concentrated market, and those index funds feel the benefits of diversification across all firms in that market exceed the benefits of influencing corporate governance, they could commit not to communicate with management or vote their shares.'"

I believe that is the case now: index funds don't vote or attempt to influence management (at least I've never heard of it). Also, each individual fund is limited in the proportion of an individual company it can own, but that limit does not apply to the total sum of index funds.

"If you think that institutional investors are causing managers to stop competing, there are more plausible mechanisms for that than voting. Just leaving managers alone, for instance, probably itself tends toward anti-competitiveness: If shareholders don't pester management, they will probably compete less hard, just because that is easier. 'Voting with their feet' is another: If shareholders invest indifferently in both the best and the fourth-best firm in an industry, that will keep up the fourth-best firm's stock price and lower the best's, reducing incentives to be the best. Or there is just fiduciary duty: Managers may want to do what's in their shareholders' best interests because that is what they are supposed to be doing. Even if the shareholders don't actively force them to."

In fact, as I understand it, index investing is just an end-spectrum case of institutional investing in general, and "Posner and Weyl blame institutional investors for income inequality. Elhauge blames them for runaway executive pay, and for the rise in corporate profits unaccompanied by economic growth and investment."

Runaway executive pay, for example, seems to be a consequence of interlocking executive roles: the manager of this company is a director of that, and vice-versa, resulting in a positive feedback loop.

I am, and have been for a long time, a major index investor; a big chunk of my portfolio is in various indexes. But it's already the case that a good way to get an extra boost is to buy the shares of a company just before it enters the S&P500. If the indices are having effects in the other direction, there may be problems in store.

How about this for a universal law?

Nothing in economics is an unbalanced positive.

kspaans3• 11 years ago

Vanguard definitely uses its proxy votes:

https://about.vanguard.com/vanguard-proxy-voting/

cmsmith• 11 years ago

The article's focus on the temptation for collusion seems overblown to me. Yes, the interests of Pepsi+Coke's index shareholders are served if the companies avoid cannibalizing each other's value, but those shareholders have no way to apply pressure on the companies to do that. Index shareholders do not vote, and by their nature cannot sell shares of a company that they are displeased with.

The other concern seems more well-placed. An efficient market requires that shareholders buy and sell companies in response to performance. Index funds buy and sell companies in response to the performance of the fund, or the market as a whole, or some other arbitrary factor. If 50% or 80% or 90% of a company is owned by 'dumb' funds, what does that do to their market value? And how could that affect the choices of the CEO?

kspaans3• 11 years ago

Vanguard may invest passively, but they claim to do active things with their proxy votes:

https://about.vanguard.com/vanguard-proxy-voting/

gnopgnip2• 11 years ago

The index funds are rebalanced frequently. If an individual ticker is delisted(usually due to size or mergers) those stocks get sold.

bickfordb• 11 years ago

If index funds create larger voting blocks of shares, wouldn't that create a more powerful pool of voting power to influence changes than if all shareholders were voting individually? Index funds could turn over voting control to a proxy/research based voting service or survey their investors to determine how to vote.

I'm embarrassed to admit I actually don't know the voting policies of the major index funds I'm invested in (VTI, AGG mostly).

saryant3• 11 years ago

http://www.vanguard.com/pub/Pdf/sai040.pdf

Page 45.

elipsey• 11 years ago

The quote "stock acquisitions that create such anticompetitive horizontal shareholdings are illegal under current antitrust law" doesn't seem to include any reference that I can find to any original text written by Elhauge. Instead the footnote links to a bunch of the author's own articles about Elhauge.

The only properly cited textual evidence offered is a series of denials by Elhauge that he ever said index funds are illegal.

Levine has been writing about this for months in articles with linkbait titles like: "Should Mutual Funds Be Illegal?" (http://www.bloombergview.com/articles/2015-04-16/should-mutu...) and "Labor Department Wants to Tweak Your Retirement Plan" (http://www.bloombergview.com/articles/2015-04-15/labor-depar...)

It seems like Levine has an axe to grind with regulators, and doesn't want anyone to talk about research that might suggest regulation. He might be right, but he is making a crappy argument.

EDIT: Ok, I stand corrected. Elhauge totally said that. It's in the abstract. I had trouble finding it because Levine cited himself instead of the paper at the end of that that paragraph. Sorry.

ikeboy• 11 years ago

That's a direct quote from the linked paper http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2632024

anigbrowl2• 11 years ago

More likely he just mixed up his URLs with his anchor text. Linked from 'Elhauge claims to disagree with my interpretation': http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2632024

paulpauper• 11 years ago

index allocation as a % of total assets will keep rising, but total assets will also keep rising.. That means individual stocks will still have price discovery despite a futuristic scenario where 99% of all money is indexed. The mechanism for how this leads to collusion is unclear.

sandworm1013• 11 years ago

Why the assumption that an index must represent a market?

Wikipedia def: "An index fund (also index tracker) is an investment fund ... that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions."

The OP only discusses the former, not the later. I see the point that an indexed fund tied to a specific market, the narrower the better, may bring antitrust rules into play. But the later concept, that a indexed fund is simply a fund with fixed buy rules, need not get anywhere close to antitrust. They need not have a presence across any "market" as conceived by antitrust.

How about an indexed fund with the rule: Own equal numbers of share from all publicly-traded social media firms, except facebook. Such an indexed fund might find lots of investors without getting anywhere close to antitrust.

theseatoms6• 11 years ago

Sure, index funds can track any sort of index, and use any sort of weighting scheme. But modern portfolio theory dictates that truly passive investors should hold two assets: the "market portfolio", and a "risk-free" asset such as Treasury bonds, or cash.

As other commenters have mentioned, "index investing" is better referred to as "passive investing".

sandworm1013• 11 years ago

I think the very term "indexed fund" is an artifact. Indexed funds need not be tied to an index. They can still be "passive investing" without the index.

"Antitrust" is a similar linguistic artifact as you can violate antitrust rules without any mention of trusts,

dataker2• 11 years ago

I just can't see it as something positive.

This is signaling that monopolies have massive power in their industry horizontals. 'To compete', they must take over another industry horizontal.

bcg18• 11 years ago

A bigger problem with index funds is the inherent bias they create towards consolidation of capital at the top. A company that becomes part of the S&P 500 will automatically have bi-weekly buyers of their shares as people pump money into index funds via payroll deduction. Nearly every piece of mainstream financial advice in the US suggests such behavior... "d% of mutual funds fail outperform the S&P 500" etc. Of course such comparison ignores transaction costs, administrative costs, risk, diversification across asset classes, et al. However, it leads to many people who want to "Set it and forget it" to just buy the S&P 500 index companies automatically every 2 weeks, pumping up the values of large cap corporations whether they perform well or not.

I know that companies don't necessarily benefit directly from an increasing stock price, but in reality it allows them to raise capital by issuing new shares with less dilution. Also it makes it costlier for smaller competitors to raise capital, crowding out competition. At the end of the day, the "antitrust" question is not about Apple v. Microsoft... it is moving more in the direction of "Apple & Microsoft" vs. anyone trying to claw and scrape their way into the game.

anigbrowl2• 11 years ago

transaction costs, administrative costs, risk

These are exactly the things that you generally minimize by buying an ETF (although obviously everything is in the same asset class by definition).

exelius6• 11 years ago

Yeah, I think that's exactly what OP was saying. When a fund says "we beat the S&P index fund by 5%", the actual returns to the individual may be very close to what you get from an index fund. After fees are taken into account, few mutual funds (or hedge funds for that matter) can beat an ETF on a consistent basis.

Mutual funds have their place (large, pooled plans like 401ks where there's enough money involved that fees can be negotiated come to mind); but they're probably not the best option for an individual investor. I always recommend newbie investors put most of their equity holdings in an S&P ETF for this reason; the returns on a mutual fund may be slightly higher in good years, but they'll almost always be worse in bad years.

exelius6• 11 years ago

I would argue that the impact of these "buy and hold" investors on share price is minimal. There's so much liquidity these days that any one class of investor should have a minimal impact on the share price. The index funds end up moving WITH the market, so any downward (or upward) trend will be followed by whatever balancing algorithm they use.

Your big swings in share price are still going to be driven by HFT algo traders, activist investors, hedge funds, etc.

I do agree that companies in the S&P 500 have an oversized advantage in raising capital, but if you remove index funds from the picture, I think the mere existence of the index would have a similar effect (this could be researched historically, but I don't have the time/interest to do so). On the flip side, any stock in the S&P is going to have limited arbitrage opportunity due to the level of liquidity they get from index fund rebalancing, etc.; so algo traders looking at specific plays may want to find an asset with lower liquidity and fewer eyes watching it. As with anything in finance, there is a play available on both sides of the field and they tend to balance each other out.

vegabook2• 11 years ago

Good point. Actually there is a thriving segment of the broker and hedge fund market whose entire game is figuring out which stocks will have their weights changed at each new index rebalancing, and "front-running" the index funds who can't do anything until it becomes official. Thus they profit off what is a market inefficiency, scraping value from the passive guys, which in the long run could I suppose limit the index fund phenomenon (though not the indices themselves).

mangeletti• 11 years ago

The exact opposite is true[1].

HFT affect and take advantage of minor price swings[2], and their arbitrage is based on this. Long-term investments are the primary driver of (hence) long-term price movements. After all, HFT, by definition, have no long term interests in issues, so they are (usually) equally weighted in either (long or short) direction, thus cancelling their long-term effects out, even in a situation where there are no long-term investors.

1. This pertains your comment regarding HFT. Activist investors, which you also mentioned, are just long-term investors with a marketing strategy (put your money into something and then go tell everyone), and in some cases a lobbying strategy (e.g., Bill Ackman's notable short of HLF), and they have no place being compared with HFT.

2. It is true that, sometimes, minor price swings can cause a crossing of a tipping point (e.g., below a prior price support level, etc.), but even in these cases the long-term price will adjust for these swings based on intrinsic value.

hibikir• 11 years ago

It's precisely because of the administrative costs and transaction costs that the managed mutual funds are a bad idea: They don't outperform, in the long run, if just because their transaction costs.

That's really the point: An unsophisticated investor should go with index funds over the alternatives. To beat the market regularly, you need non-public information or insight, and the market is large enough that having said insight consistently is something limited to the highly connected.

Your argument against index funds, from a market perspective, is really more about putting all that money in large cap indices. Taking index funds to their conclusion, the ideal situation would be to use broader indices. Startups will still have to deal with venture capitalists, but that's for good reason: High risk, high reward investments aren't exactly what your typical index fund investor is interested in.

bcg18• 11 years ago

You make a good point, I really was only considering major large cap indices. I assume this is what most people mean when they talk about "index funds".

I'm not really against index funds per se, I actually think they are a great way to invest if you identify a trend in a particular sector. And truthfully, I'm far from a trained financial expert, I'm just some dumb hacker that is rubbed the wrong way by the type of advice I outlined in my above comment.

3pt141593• 11 years ago

The problem with broader indexes is that they invest in stocks that are subject to less scrutiny (small caps / mid caps) so it creates a vector for a pump and dump. I'm not saying that the S&P 500 is the be all and end all of American index investing, but I wouldn't want the S&P 500k either.

prostoalex• 11 years ago

Seems like other market participants (hedge funds, individual investors) are providing a solution to this problem by analyzing inflows and outflows into such index funds and creating respective positions in case they think an index is over-bought or over-sold.

thedaveoflife• 11 years ago

Your theory directly contradicts the Efficient Market Hypothesis. If "dumb money" is flowing in to large cap funds, institutional investors should be able to take advantage.

ajross• 11 years ago

Exactly. And being a threshold, it also should be concentrated at the margin, where companies "just outside" the S&P500 should see some measurable benefit vs. the ones "just inside" the list. I'm not aware of any such analysis.

bcg18• 11 years ago

What if the efficient market hypothesis is not correct? I think that people like Warren Buffett and Jim Rogers might beg to differ with that theory.

rory096• 11 years ago

Of course such comparison ignores transaction costs, administrative costs, risk, diversification across asset classes, et al.

That's exactly why mutual funds underperform. Given the EMH, it makes more sense not to spend so much time on 'asset management' like that.

If you believe the S&P is overvalued because too many people index to it, you can invest in broader index funds and, if you're correct, yield a higher return.

eevilspock• 11 years ago

Yet another addition to my list of Matthew Effect examples and how this effect may be enemy number one, undermining entirely the notion that an unregulated free market produces a level-playing field and a meritocracy.

brc4• 11 years ago

1) There are no 'unregulated free markets'

2) Nobody -ever- has said that an 'unregulated free market produces a level playing field and a meritocracy'

The facts are that a regulated and controlled market with freedom of economic action produces the best outcomes for a population as a whole, when measured in life expectancy, social mobility and and even environmental cleanliness. Every other system that has been tried produces far worse outcomes across all these measures.

There's a persistent adolescent thought pattern running these days which says something like 'free market? Huh? Where's my lamborghini? I got nuthin' but student debt and no job'

This kind of thinking should be avoided in order to make progress on the topic.

pbreit4• 11 years ago

What's preventing an "active" manager from managing in a fashion similar to an indexer?

It seems like with a few, inexpensive tweaks, it wouldn't be too difficult to beat the index.

tobltobs• 11 years ago

Like only buy the ones whole will go up in price?

gnopgnip2• 11 years ago

The fees add up in the long term to reduce the overall returns.

forgetsusername• 11 years ago

Nothing. In fact, some active managers invest in ETFs as part of their...ETFs.

http://www.cambriafunds.com/gmom.aspx

WalterBright• 11 years ago

You can also buy index funds for the broader market, like the Russell 2000.

eru13• 11 years ago

Professional investors short-selling specific companies in the S&P 500 could undo some of these drawbacks.

mathattack• 11 years ago

Matt Levine is awesome at separating arguments from interests, and writes very clearly. He was great on Dealbreaker, and I'm glad that he's not tempering his voice on Bloomberg.

guimarin• 11 years ago

As someone who derives most of his income from the value created by start-ups disrupting incumbents, I'm all in favor of index funds making firms anti-competitive in their own industries.

11thEarlOfMar• 11 years ago

Maybe it's upside down.

Index funds effectively buy and sell at prices set by non-index fund investors. They are reacting to market price, not trying to predict where the stocks will go in the future.

All other investors are betting on the future price moving one way or the other.

I'd argue that index funds are an amplifier for demand, but that the actual demand is still generated based on 'analysis' by investors seeing the the current price as an opportunity.

chad_strategic2• 11 years ago

Index funds and ETFs will work until they don't anymore.

It always happens...

sparky_z2• 11 years ago

What always happens?

chad_strategic2• 11 years ago

It's amazing how fast people forget the past. https://en.wikipedia.org/wiki/Tulip_mania

It happens every time, if there a way to make money speculators will come into the market, take advantage of it. Or in the case of index funds, it will become overcrowded and inefficient and the market will move on to the next big thing. Just ask LTCM. It's the invisible hand of the market...

Honestly, anybody that down voted me is probably invested heavily in index funds because they heard something on a blog and listened to Warren Buffet once.

animefan• 11 years ago

One problem with this argument is that it ignores the fact that investors are also consumers. If the representative investor is also the representative consumer, then managers who aim to maximize shareholder utility will not set monopoly prices, but rather competitive prices! Of course, like the author I don't think any of this bears out in reality.

roymurdock• 11 years ago

Which institutional investor should I specifically be concerned about?

Show me the institutional investor that owns 30% of American, 30% of Delta, 30% of Southwest, and 30% of United. [1] If this is the case, then yes we have a problem. The manager of this fund has a major incentive to have these 4 major firms collude and price gouge its customers, as competition among the firms would minimize profit for the index fund. It would major shares of the companies that own the entire market. I think it's safe to say that this institutional investor doesn't exist.

Which concentrated group of 3-4 (oligarchy) institutional investors own a combined 50% of American, 50% of Delta, 50% of Southwest, and 50% of United?

If this is the case, then yes, we have a problem. Collusion will occur between these funds, who will agree to use their voting/management rights to collude at the airline level, as they own the companies that own the market.

We're usually used to seeing collusion between the CEO's and boards of major companies in concentrated markets because we tend to think of these people as the people who profit the most from price gouging. Antitrust lawsuits against AT&T, Kodak, Standard Oil - these are all pretty concrete examples of collusion from brands that we (used to) interface with. [2]

Now we could be seeing collusion abstracted one layer - the owners/shareholders are institutional investors who don't have a well-known brand. Which institutional investors specifically should we be worried about? Unlike AT&T + Verizon, I don't interface directly with any of them, so I'm not sure which firms I should be concerned about.

Where's the data?

[1] 30% is an arbitrarily large number.

[2] http://www.hg.org/article.asp?id=6025

nradov• 11 years ago

Based on the latest market data, the largest holder of AAL, DAL, LUV, and UAL is Vanguard which through various mutual funds owns 11.5% of the total market value of those four airlines. Second largest holder is T.Rowe Price with 6.8% of the total ownership. Concentration of ownership goes down rapidly from there. So it's hard to see this as a real problem.

jwatte• 11 years ago

For an individual index fund, who is making the argument that it's big enough for anti trust? If one fund owns 1% of American Airlines, and 1% of United Airlines, they have no monopoly/dominating power over either.

morgante2• 11 years ago

This is a fascinating line of thought and, at least from a game theoretic perspective, seems to be a mechanism for creating automatic, passive collusion between companies.

If we model the market as a prisoner's dilemma where a lawyer is deciding whether their client should defect or not, mutual defection is the normal Nash equilibrium. But if both lawyers are representing the same client then cooperation becomes the dominant strategy: regardless of what the other lawyer does (cooperate-defect and cooperate-cooperate both have higher total payoffs than defect-defect).

Notably, this mechanism is entirely passive: it requires no communication between managers or even managers and their investors. Merely knowing that my investors are also investors in my biggest competitor would make "cooperation" the dominant strategy without requiring any conscious collusion.

Taken to the extreme, this actually undermines the entire free market: every manager in a 2+ place firm would have a fiduciary responsibility to drive their company out of business so that the first place firm could enjoy monopolist profits (and thus maximize their shared investor's total return).

assaflavie• 11 years ago

Say index funds become illegal, just for the sake of argument. Aren't they replaceable by an algorithm - trading software that balances a portfolio that copies an index per investor? It's less efficient, of course, but it's essentially the same thing. You get millions of tiny, cross-sector owners instead of few big index funds. So in that sense the argument in favor of banning index funds is really pointless. They're just one implementation of a strategy that investors could follow on their own, just less efficiently. Essentially, banning them is just a way of enriching brokers because of the expected rise in transaction fees.

Index Funds May Work a Little Too Well

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