Much Ado About Nothing: The Impact of Diversified Funds on Competition (Part 2)

A new line of research suggests that diversification across stocks in an industry can reduce competition, but that argument is weak.

Alex Bryan 08.03.2018
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In part 1, we discussed the assumptions for the common ownership argument to work. In part 2, we will discuss if index managers would benefit from common ownership.

A More Holistic View
Suppose that the common ownership argument is accurate: That index (and other diversified asset) managers look the other way while firms adopt less competitive behavior to increase industry profits. It isn't necessarily in asset managers' interest to do that. Rather, if they were able to affect how companies competed with one another, it would be in their interest to use that influence to maximize the value of their entire portfolios. That means they would favor their larger holdings over their smaller holdings, and might even benefit from greater competition (and lower prices) in some industries whose goods and services are expenses for their holdings in other industries. Take the energy industry, for example. Energy stocks represent less than 6% of Vanguard Total Stock Market ETF (VTI, listed in the U.S.), but energy prices affect most companies' expenses. Greater competition in this sector might be better for index investors than less. The banking and airline papers ignore these cross-industry effects.

With this in mind, it isn't obvious that index managers would benefit much at all from oligopolistic behavior in the airline industry. Airline stocks represent a small fraction of most index funds (less than 0.5% of VTI), and yet travel expenses impact most publicly traded companies. Higher ticket prices especially hurt the hotel, restaurant, and leisure industry, which represents a larger portion of most indexes than the airline industry. This demonstrates that the net effects of less competition and higher prices in one industry aren't necessarily beneficial for diversified asset managers. 

What About the Airline and Banking Industries?
The papers that documented a positive relationship between common ownership and prices in the airline and banking industries shouldn't be dismissed outright. But more empirical evidence is needed to establish that greater common ownership causes higher prices, and that they don't just happen to move together. It is difficult to isolate the impact of common ownership on competition because there are many factors at work.

It is also important to note that both papers relied on limited data. The airline paper examined data from 2001 through 2014, while the banking paper included data from 2003 through 2014. Both industries experienced considerable consolidation over these periods. Also, many airlines emerged from bankruptcy during this span and have since taken a more rational approach to pricing. The findings may well be valid, but we should reserve judgment until the analysis can be applied to more industries and markets over longer periods with appropriate controls.

Don't Kill Index Funds
It is a bad idea to act on the emerging research suggesting that common ownership of stocks in the same industry reduces competition, leading to higher prices. That argument rests on some questionable assumptions, and it is difficult to empirically isolate the impact of common ownership on competitive behavior. Even if an increase in common ownership led to less competition, it makes more sense to address it through traditional antitrust actions than by placing onerous limits on diversification that would effectively dismantle large index funds, or voting rights.

Index funds have provided enormous benefits to millions of investors. To justify taking those benefits away, common ownership would need to have a big impact on competitive behavior: Much bigger than the 3%-7% price impact that the airline paper found. A harsh policy response is unlikely under the Trump administration but could become a bigger threat in the future.



1) (Airline Paper) Azar, J., Schmalz, M.C., & Tecu, I. 2017. "Anti-Competitive Effects of Common Ownership." Journal of Finance. Working Paper (March):

2) (Banking Paper) Azar, J., Raina, S., & Schmalz, M.C. 2016. "Ultimate Ownership and Bank Competition." IESE Business School. Working Paper (July):




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Alex Bryan

Alex Bryan  Alex Bryan, CFA is the Director of Passive Fund Research with Morningstar.

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