Index funds rocking in hard places
Investors who have been searching for ways to make healthy returns on their investments, without having to pay a chunk of their profit in fees to a fund manager, are increasingly gravitating to index funds.
These baskets of stocks, which aim to replicate stock indices such as the JSE all-share index, don’t aim to beat the market, just to match it. Investors can pay low fees on passive funds, such as Satrix, and see similar returns to their actively managed counterparts. Although index funds have been around for decades, they have gained prominence and popularity in the past few years.
“Index funds are finally sexy,” wrote financial commentator Joe Nocera for Bloomberg in April.
Many see the rise of index funds as the “democratisation” of the investor world, where fees to top-paid traders on Wall Street (or Gwen Lane, as it were) take the knock and the investor on the street gains.
But a growing argument, which started in the United States where index funds make up the biggest relative portion of the investor market in the world, says the common ownership precipitated by these funds could be hurting consumers.
Melissa Newham, Jo Seldeslachts and Albert Banal-Estanol, in their recent paper, Changes in Common Ownership of German Companies, explain how this might happen.
“Institutional investors are entities that invest money for others. They include mutual funds, endowments, banks, pension funds, insurance companies and hedge funds. Institutional investors in general have a lot of money to invest and typically diversify their holdings across many companies. This results in the same investor owning equity shares in several companies at once, a phenomenon called ‘common ownership’. Some of these common holdings can create indirect links among companies operating in the same product market.
“Investors that have (even relatively small) block holdings in several competitors at once can have strong effects on the competitive outcomes of an industry. That is, decision-makers in a firm may decide not to compete aggressively against a competitor that is (partially) owned by the same investors.”
In the US, passive investment megafirms, such as Vanguard and BlackRock, hold stakes in several companies in the same industry. The argument is that their influence is enough to change the behaviour of the company.
This is not always a bad thing. “Firms may invest more in research and development, and perhaps even co-ordinate their innovation activities through research alliances. This could result in more innovative products and more efficient production processes, which ultimately benefit consumers.”
But consumers could also suffer.
“The managers of firms A and B may also have less incentive to compete aggressively in product markets than if there were no common ownership, even if the two firms set prices independently. The resulting higher prices are to the detriment of consumers.
“In the worst case, common ownership might make it easier for firms A and B to even co-ordinate on prices through tacit or explicit collusion,” the authors write.
Small stake, big players
But could passive investors really have this kind of influence, bearing in mind that they generally hold less than 10% of any company?
Yes, according to Newham.
A competition researcher at the institute for economic research DIW Berlin and KU Leuven university in Belgium, she recently worked at the Centre for Competition Regulation and Economic Development (CCRED) in Johannesburg.
“Even though large passive investors such as Vanguard may only have a stake of around 5% to 7% in a company, this is often enough to position them as one of the top investors in the company,” she said.
“For example, the single largest shareholder of Apple and Microsoft is Vanguard. In the US, BlackRock, Vanguard and State Street together constitute the largest shareholder in almost 90% of S&P 500 firms. The largest shareholders of a firm can influence policies and decisions.”
Professor Simon Roberts, CCRED’s director, contends that the behaviour arising from common ownership is not about explicit co-ordination or cartels, per se.
“If you have got common shareholders, they could reach an understanding that it’s not in the best interest of the shareholders to compete head to head, but it would be more beneficial to segment the market between competitors, or each target different geographic areas,” he said. “It’s more likely that they will evolve their strategy to dampen competition.”
But what about in South Africa, where the index funds are less mature and make up a smaller proportion of the investor market?
“It depends on how concentrated the index fund industry is, as to determine whether or not this will result in increases in common ownership,” Newham said.
“In the US, from the start, the passive fund industry was dominated by BlackRock, Vanguard and State Street, so ownership has become concentrated in the hands of a few large investors. If there are more alternatives for index fund investing in South Africa, ownership will be less concentrated in the hands of a few investors, and each individual investor would have less influence.
“Although, if diversified index investors similarly benefit from raising industry profits through reduced competition and are able to co-ordinate on this goal, then valid concerns will arise as passive index investing increases in popularity.”
Roberts said research into the effects of common ownership in South Africa is on CCRED’s agenda.
But Steven Nathan, the chief executive of South African investment firm 10x Investments, which adopts a “low fee index tracking approach”, has dismissed these arguments.
“Basically, I think it’s complete nonsense and I’ll tell you why. Let’s compare the US market, where index funds are prominent, to Europe, where they are not. The US market is recovering well from the 2008 financial crisis. The European markets are battling to do so. The US economy is growing better than European markets.”
Anti-competitive arguments assume that index fund managers are going to play an active role in the boards of these companies, which is not always the case, Nathan said.
“Look at Allan Gray with Naspers,” he said, pointing out that, although the investment firm owns a major stake in Naspers, it has little sway over Chinese-based Tencent, Naspers’s flagship company.
BlackRock has punched holes in the research conducted into common ownership, disputing the argument that common ownership could lead to higher prices.
It also challenged the need for policy change to protect investors from the possible hazards of common ownership. “These policy proposals are, at best, premature.”
Other common ownership woes
Melissa Newham points out that “other institutional investors and investment holding companies can own shares in multiple firms in the same industry.”
In South Africa, by far the largest single investor in publicly listed companies is the PIC, she said.
“Based on my analysis of the Thomson Reuters Global Ownership database, the PIC has significant stakes in over 100 publicly listed South African companies. On average, the size of their stake is 10%.”