Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.
On Monday, I introduced the idea that the rise of indexing and ETFs, known collectively as passive investing, is damaging the market and the economy, and I started spinning out the worst-case scenario should it continue to advance, including a riskier stock market and widening income inequality. But there are other areas to worry about as well.
Innovation
Competition is what academics worry about when they worry about passive investing. Traditionally, preserving competition was mostly about maintaining a certain number of companies in every industry. Federal antitrust laws block monopolies. But academic studies have shown recently that index funds or horizontal ownership, where the same investors own a good percentage of the shares in rival companies, can also stifle competition. Horizontal ownership has risen sharply in the past decade and a half. For a large company, the chance that at least one of its large shareholders owns shares in a rival has risen to 90 percent, up from just 16 percent in 2000. And the more horizontal ownership there is, it appears, the less competitive a company, and an industry, becomes. In 2014, two economic consultants, Jose Azar and Isabel Tacu, and a Michigan economics professor, Martin Schmaltz, found that in the airline industry, where common ownership had risen to 70 percent, prices were as much as 12 percent higher because of common shareholders.
But the bigger problem is not prices but innovation. If CEOs have an incentive not to compete, then they might not try all that hard to innovate, spending less on research and development. Indeed, R&D spending has slumped since the 2008 financial crisis. Late last year, a study by a New York University professor, Thomas Philippon, and a graduate student, German Gutierrez, examined the reasons R&D spending has been weaker than expected since at least 2002 but plunged after the Great Recession.They found only three factors that at least mathematically appeared to correlate with the drop in R&D. One was an increase in index investors.
The effect on investing, and the economy in general, is immense….