Index Funds’ Populist Threat

Any observer of recent socio-political trends has noticed the rising impact of populism in the United States and abroad. The 2017 Edelman Trust Barometer explained that “current populist movements are fueled by a lack of trust in the system and economic and societal fears …. Countries coupling a lack of faith in the system with deep fears, such as the U.S., U.K. and Italy, have seen the election of Donald Trump, the Brexit vote and the failed Italian referendum.” The Atlantic recently noted, “Sentiments were similar back in the 1920s, the last period of high levels of corporate concentration and inequality. Isolated protests against big business erupted periodically then as they do now.”

The policy implications of this trend are broadly understood. However, populist themes are now finding their way into important policy debates that can have significant implications for financial market participants. Index fund managers are now engaged in one such debate.

In contrast to actively managed funds, which try to beat the market by relying on unique skill or research, index funds are constructed to mirror the returns of a market index, such as the S&P 500, by passively tracking its components. As the popularity of index funds has grown, the market has seen an increase in broadly diversified stock ownership, with investors commonly owning interests in many companies, even within the same industry. The question now presented to policy makers: Do index funds produce anti-competitive effects in the market? The question for index fund managers: How do we convince stakeholders that index funds are not anti-competitive?

The roots of this argument stem from theories about common ownership. For decades, U.S. antitrust regulation has been predicated on the idea that as the number of firms in an industry decreases, so too does the competition. However, recent research has suggested that, regardless of the number of companies in an industry, as the number of shareholders those companies have in common increases, the less incentive there is to compete. This is the essence of common ownership theory. The implication? More common shareholders results in worse consumer outcomes (e.g., price increases).

Index fund managers have been quick to push back on this idea by highlighting flaws in the research and the potential negative impacts for investors resulting from policy proposals. But will this be enough to hold back rising populist sentiments?

The answer is no. Those pushing for new policies designed to rein in the purported anti-competitive effects of common ownership make one clear assertion: Index funds increase prices for consumers.

While the financial industry has suggested that the current academic research is flawed and that investors would be harmed by undermining index investing strategies, the industry has yet to make a clear argument for why index investing is good for consumers at large. Ultimately, policy makers are responsive to their constituents, and their constituents are looking increasingly populist. For index fund managers, the best communication strategy to address the challenge of common ownership theory is one that plainly shows the benefits to consumers, not just investors.

Index funds have done wonders for reducing costs for those who want to invest in the market. Now the challenge is to show that they haven’t raised costs for everyone else.

Chris Donahoe is a vice president, Financial Communications and Capital Markets, Edelman Washington, DC.

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