There have been a number of books in recent years that look at growing industry concentration. Cornered by Barry C Lynn and The Myth of Capitalism by Jonathan Tepper and Denise Hearn are the two I've been reading recently. Both tell a similar story of how the number of companies within a number of industries has become increasingly concentrated, undercutting the proposition that actually existing capitalism is really all about competition and innovation.
US airlines are often cited as an example where there is a very limited number of companies, with de facto regional monopolies. Lynn provides a bunch of other interesting examples, like the domination of opticians by Luxottica, a company most of us have probably never heard of. Or try buying certain products - in person, rather than online - without going to Walmart (online, obviously, Amazon dominates). He describes this as Hydra-like - multiple heads on the same body - which is a nice way of describing it.
So far, so familiar. But what both books, and others I've been reading, also focus on is the concentration of ownership of those monopolies. For example, Tepper and Hearn cite research showing that in 1980 if you paired any two US firms 75% of them would have no common shareholder. By 2012 that figure had dropped to 8% (which actually sounds quite high to me).
Obviously the growth of passive investing, and therefore the growth of passive managers, is a major part of the story. For example, the proportion of shares of the S&P 500 held by the Big 3 - BlackRock, Vanguard and State Street - has risen from 9.1% in 2002 to 18.4% in 2018. Between them hold roughly 15% or more of all the big US banks. And we can see similar things at work in other countries, if not quite so pronounced.
But why does it matter? There are differing views on this in the books I've been reading, so here are a few arguments.
1. There's a risk that concentrated/cross-ownership of oligopolies reduces competitive pressure even further. Here's a take from the Left (from The People's Republic of Walmart):
"An investor who has holdings on one airline or telecom wants it to outperform the others: to increase its profits, even if temporarily, at others' expense. But an investor who owns a piece of every airline or telecom, as occurs in a passively managed index fund, has drastically different goals. Competition no longer matters; the overriding interest is squeezing the most out of customers and workers across an entire industry - no matter which firm does it. In principle, capitalist competition should unremittingly steer the total profits across a sector dow, ultimately to zero. This is because even though every firm individually aims for the highest possible profit, doing so means finding ways to undercut competitors and thus reduce profit opportunities sector-wide. Big institutional investors and passive investment funds, on the other hand, move entire sectors toward concentration that looks much more like monopoly - with handy profits, as firms have less reason to undercut each other."Tepper and Hearn make the same point:
"Concentration of ownership is problematic because it distills the control of entire industries into a few players' hands. But even more concerning is that recent studies are suggesting that common ownership incentivises firms to avoid competing with each other altogether... In a situation with horizontal share ownership, where firms are trying to please the same owner, firms can tacitly collude to maintain high corporate profits by swelling total industry performance. Investors make money when the industry (not individual companies0 makes money. The easiest way to do this is to raise consumer prices."They go on to use the example of US airlines and banks where concentrated common ownership is correlated with increased prices / fees. They also suggest that industries with concentrated common ownership tend to invest less and spend more on stock buybacks.
2. Barry Lynn argues that the shift to indexing puts more power back in the hands of corporate leaders:
"[T]he mutual funds socialised the small investors' ownership stake by broadening it to the point of destroying any sense of common interest between the average small investor and any one company. As a result... the real power shifted way from us to the fund managers and the financiers, who supposedly did our bidding but who instead used our gold to forge the fetters with which to bind us."3. What about intangibles? A really interesting line of argument comes from Jonathan Haskel and Stian Westlake in Capitalism Without Capital. They argue that highly diversified investors will be more open to investment in intangibles that has spillover effects, as they own all the shares in an industry and thus while value might be lost in the firm making the investment, it is gained by those taking advantage of it. But they also point out that diversified means thinly spread, so only those with concentrated ownership will have the incentives to put the time in to understand and value intangible investment.
"The greater uncertainty of intangible assets and decreasing usefulness of company accounts put a premium on good equity research and on insight into fund management. This will present a challenge to investors, partly because funding equity research is becoming harder for many institutional investors as regulations are tightened, and partly because of the inherent tension between diversification (which allows shareholders to gain from the spillover effects of intangible investment) and concentrated ownership (which reduces the costs of analysis)."Of course, as outlined earlier, what we see with the growth of passive management is the combination of diversification and concentration. Passive managers are often the largest shareholders, and as a block hold a major chunk. In such a scenario my strong feeling is that the diversification aspect is going to easily trump the theoretical reduced research cost.
Think how much more research would cost on all the stocks where BlackRock is a major (say 5%+) shareholder. And while you are thinking about that, also consider the price war on index funds. Blackrock uses stock lending to keep its fees low. Vanguard uses 'heartbeat trades'. I've seen some examples where passive managers are almost giving the product away to big clients. These do not look like firms that are going to spend a lot of money on research. Which is why I asked previously what business some asset managers are actually in.
Of course there will always be active managers out there which take big positions and do the research. But overall they are going to be outweighed by the assets of low-cost index-trackers. I don't see widespread quality analysis of intangibles emerging from this any time soon. If there's no encouragement to invest, because there's an oligopoly in the industry and firms can find other ways to make money, and investors are unlikely to do the research that would put a value on intangibles anyway, well....
For my part, my gut feeling is that, overall, the rise of indexation results in less scrutiny of public companies, certainly over business-critical issues. BlackRock's role in Carillion was a good example here, where it engaged over remuneration with a business clearly facing an existential threat. As such I'm drawn to Lynn's argument that the net result is a re-concentration of power in the hands of corporate leaders.
I actually think that's OK on one level. If we want cheap way to get equity returns, then low-cost passive funds are a good option. But I think that we ought to question why asset managers need to be involved in voting and engagement at all in such a scenario. If you're holding UK stocks purely because they're in the FTSE, why do you need to follow what Larry Fink's team's views on, say, how much the directors should be paid?
But that's another story...
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