
Index Funds May Work a Little Too Well - chollida1
http://www.bloombergview.com/articles/2015-07-22/index-funds-may-work-a-little-too-well
======
bcg1
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.

~~~
pbreit
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.

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

~~~
pbreit
Part of acting like an index fund would be keeping fees low.

~~~
adestefan
Then just buy the index fund. I can buy an index fund that has fees of 0.2%.
If the managed fund has fees of 1.2% that means it needs to beat the index by
at least 1% to come out even. If you can beat an index by 1% while trying to
replicate an index, then you're either a genius or cheating.

The numbers are even worse if it's in a taxable account. That means you need
to beat both the management fee and the taxes because you'll end up paying
taxes for all the turnover too.

~~~
pbreit
Well the idea is to beat the indexes on a net basis. The fees would be much
lower (than 1.2%) because it would not be very active. It would be replicating
the index (which lots of people can do fairly easily) but with a tweak or 2
like a slight change in weighting or trimming the 50 worst X or lopping off
the 10 biggest caps. I've seen some back-testing on stuff like this that can
get you that extra point or 2.

------
howeyc
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).

~~~
aetherson
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.

~~~
blueside
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?

~~~
hsitz
Because both companies are on the index that the index fund matches, and the
whole premise behind index funds is that they're set up to require their
managers to purchase stock of all companies in the index (managers not allowed
to pick and choose).

------
elipsey
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...](http://www.bloombergview.com/articles/2015-04-16/should-mutual-funds-
be-illegal-)) and "Labor Department Wants to Tweak Your Retirement Plan"
([http://www.bloombergview.com/articles/2015-04-15/labor-
depar...](http://www.bloombergview.com/articles/2015-04-15/labor-department-
wants-to-tweak-your-retirement-plan))

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

------
praptak
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.

~~~
TeMPOraL
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.

~~~
dragonwriter
> 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.

~~~
triangleman
If you define capitalism as "property laws allowing ownership of capital" and
further define it as "laissez-faire" meaning that the state does not use its
power to promote or restrict particular firms or outcomes, then at the very
least you will get the promotion of competition between industries, plus
eventual limits to what a firm can do.

For example, if a monopoly in airlines leads to prohibitively expensive plane
tickets, then competition from bus lines will serve as a control, and the
monopoly for "all transportation types" will be reduced. Unless of course you
have the airlines buying out the bus lines. But even in that case, there is a
limit to how much they can charge because a new firm can enter and make a new
capital investment in that industry. So at most, the monopolist can charge
whatever rate would make it prohibitively expensive to enter that industry.

~~~
TeMPOraL
I can see several strategies you could use under conditions you described to
maintain your monopoly if you're already big. You could, for instance,
immediately buy out any serious competition before it becomes dangerous. Or,
since you're a big player with deep coffers, upon seeing an upstart you could
start operating at a loss an just wait until your competitor runs out of
capital, and then bring the prices back up. Defeating you would require a lot
of people coordinating to hit you at the same time, and we all know that
people suck at coordination (and if somehow they managed to orchestrate such
an operation, it wouldn't take much to bribe a participant and turn him into a
defector in order to derail the whole group).

Or you could just hire a hitman. There's no concept of "fair play" in the
"physical order of nature".

~~~
eru
> You could, for instance, immediately buy out any serious competition before
> it becomes dangerous.

That's great. So your are writing free puts to my startups' equity?

Ie after you buy me out, I can go and start a new company, threatening to
compete again.

------
obblekk
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.

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

~~~
obblekk
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).

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

Only if the industry has a low barrier to entry.

------
morgante
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).

------
roymurdock
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](http://www.hg.org/article.asp?id=6025)

~~~
nradov
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.

------
sandworm101
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.

~~~
theseatoms
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".

~~~
sandworm101
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,

~~~
theseatoms
I agree we should get away from the term "index fund", but for better or
worse, investors are hung up on indices. Why do we talk about the S&P 500? Why
not 1k? etc.

Don't get me started on the price-weighted Dow...

~~~
adestefan
We do. The S&P 500 is the classic index that tracked, but it's hardly the only
one these days.

------
dataker
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.

------
bickfordb
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).

~~~
saryant
[http://www.vanguard.com/pub/Pdf/sai040.pdf](http://www.vanguard.com/pub/Pdf/sai040.pdf)

Page 45.

------
11thEarlOfMar
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.

------
cmsmith
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?

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

[https://about.vanguard.com/vanguard-proxy-
voting/](https://about.vanguard.com/vanguard-proxy-voting/)

------
assaflavie
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.

------
paulpauper
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.

------
jwatte
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.

------
guimarin
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.

------
mathattack
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.

------
animefan
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.

------
curiousjorge
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.

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

It always happens...

~~~
sparky_z
What always happens?

~~~
chad_strategic
It's amazing how fast people forget the past.
[https://en.wikipedia.org/wiki/Tulip_mania](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.

------
VLM
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.

~~~
stdbrouw
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.

~~~
VLM
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.

