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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

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. 

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About Author

Alex Bryan

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

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